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A Comparison of Single Factor Markov-Functional and Multi Factor Market Models

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  • Pietersz, R.
  • Pelsser, A.A.J.

Abstract

We compare single factor Markov-functional and multi factor market models for hedging performance of Bermudan swaptions. We show that hedging performance of both models is comparable, thereby supporting the claim that Bermudan swaptions can be adequately riskmanaged with single factor models. Moreover, we show that the impact of smile can be much larger than the impact of correlation. We propose a new method for calculating risk sensitivities of callable products in market models, which is a modification of the least-squares Monte Carlo method. The hedge results show that this new method enables proper functioning of market models as risk-management tools.

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File URL: http://repub.eur.nl/pub/1930/ERS%202005%20008%20F&A.pdf
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Bibliographic Info

Paper provided by Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam in its series ERIM Report Series Research in Management with number ERS-2005-008-F&A.

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Date of creation: 03 Apr 2005
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Handle: RePEc:ems:eureri:1930

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Postal: RSM Erasmus University & Erasmus School of Economics, PoBox 1738, 3000 DR Rotterdam
Phone: 31-10-408 1182
Fax: 31-10-408 9020
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Web page: http://www.erim.eur.nl/
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Keywords: Bermudan swaption; Greeks for callable products; Markov-functional model; hedging; market model; smile; terminal correlation;

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