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On the Suboptimality of Single-Factor Exercise Strategies for Bermudan Swaptions

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Author Info
Svenstrup, Mikkel () (Department of Finance, Aarhus School of Business)
Abstract

In this paper we examine the cost of using recalibrated single-factor

models to determine the exercise strategy for Bermudan swaptions in a

multi-factor world. We demonstrate that single-factor exercise strategies

applied in a multi-factor world only give rise to economically insignificant

losses. Furthermore, we find that the conditional model risk as defined

in Longstaff, Santa-Clara & Schwartz (2001), is statistically insignificant

given the number of observations. Additional tests using the Primal-Dual

algorithm of Andersen & Broadie (2001) indicate that losses found in

Longstaff et al. (2001) cannot as claimed be ascribed to the number of

factors. Finally we find that for valuation of Bermudan swaptions with

long exercise periods, the simple approach proposed in Andersen (2000)

is outperformed by the Least Square Monte Carlo method of Longstaff &

Schwartz (2001) and, surprisingly, also by the exercise strategies from the

single-factor models.

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Publisher Info
Paper provided by University of Aarhus, Aarhus School of Business, Department of Business Studies in its series Finance Working Papers with number 02-24.

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Length: 38 pages
Date of creation: 09 May 2003
Date of revision:
Handle: RePEc:hhb:aarfin:2002_024

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Postal: The Aarhus School of Business, Fuglesangs Allé 4, DK-8210 Aarhus V, Denmark
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Related research
Keywords: Bermudan swaption; American option; Least Square Monte Carlo; Libor Market Model; Model Risk; Model Calibration;

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  1. Pierre Collin-Dufresne & Robert S. Goldstein, 2002. "Do Bonds Span the Fixed Income Markets? Theory and Evidence for Unspanned Stochastic Volatility," Journal of Finance, American Finance Association, vol. 57(4), pages 1685-1730, 08. [Downloadable!] (restricted)
  2. Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330. [Downloadable!] (restricted)
  3. Rasmussen, Nicki Søndergaard, 2002. "Efficient Control Variates for Monte-Carlo Valuation of American Options," Finance Working Papers 02-17, University of Aarhus, Aarhus School of Business, Department of Business Studies. [Downloadable!]
  4. Leif Andersen, Jesper Andreasen, 2000. "Volatility skews and extensions of the Libor market model," Applied Mathematical Finance, Taylor and Francis Journals, vol. 7(1), pages 1-32, March. [Downloadable!] (restricted)
  5. Miltersen, Kristian R & Sandmann, Klaus & Sondermann, Dieter, 1997. " Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Journal of Finance, American Finance Association, vol. 52(1), pages 409-30, March. [Downloadable!] (restricted)
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  6. Wolfgang Bühler & Marliese Uhrig-Homburg & Ulrich Walter & Thomas Weber, 1999. "An Empirical Comparison of Forward-Rate and Spot-Rate Models for Valuing Interest-Rate Options," Journal of Finance, American Finance Association, vol. 54(1), pages 269-305, 02. [Downloadable!] (restricted)
  7. Driessen, J. & Klaassen, P. & Melenberg, B., 2000. "The performance of multi-factor term structure models for pricing and hedging caps and swaptions," Discussion Paper 93, Tilburg University, Center for Economic Research. [Downloadable!]
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  8. Jensen, Malene Shin & Svenstrup, Mikkel, 2002. "Efficient Control Variates and Strategies for Bermudan Swaptions in a Libor Market Model," Finance Working Papers 02-23, University of Aarhus, Aarhus School of Business, Department of Business Studies. [Downloadable!]
  9. T. Clifton Green & Stephen Figlewski, 1999. "Market Risk and Model Risk for a Financial Institution Writing Options," Journal of Finance, American Finance Association, vol. 54(4), pages 1465-1499, 08. [Downloadable!] (restricted)
  10. Longstaff, Francis A. & Santa-Clara, Pedro & Schwartz, Eduardo S., 2001. "Throwing away a billion dollars: the cost of suboptimal exercise strategies in the swaptions market," Journal of Financial Economics, Elsevier, vol. 62(1), pages 39-66, October. [Downloadable!] (restricted)
  11. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-50, July. [Downloadable!] (restricted)
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