On the Suboptimality of Single-Factor Exercise Strategies for Bermudan Swaptions
AbstractIn 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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by University of Aarhus, Aarhus School of Business, Department of Business Studies in its series Finance Working Papers with number 02-24.
Length: 38 pages
Date of creation: 09 May 2003
Date of revision:
Contact details of provider:
Postal: The Aarhus School of Business, Fuglesangs Allé 4, DK-8210 Aarhus V, Denmark
Fax: + 45 86 15 19 43
Web page: http://www.asb.dk/about/departments/bs.aspx
More information through EDIRC
Bermudan swaption; American option; Least Square Monte Carlo; Libor Market Model; Model Risk; Model Calibration;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-05-15 (All new papers)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Gupta, Anurag & Subrahmanyam, Marti G., 2005. "Pricing and hedging interest rate options: Evidence from cap-floor markets," Journal of Banking & Finance, Elsevier, vol. 29(3), pages 701-733, March.
- 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.
- Driessen, J.J.A.G. & Klaassen, P. & Melenberg, B., 2000.
"The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions,"
2000-93, Tilburg University, Center for Economic Research.
- Driessen, Joost & Klaassen, Pieter & Melenberg, Bertrand, 2003. "The Performance of Multi-Factor Term Structure Models for Pricing and Hedging Caps and Swaptions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(03), pages 635-672, September.
- 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.
- 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.
- Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-50, July.
- 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.
- Miltersen, K. & K. Sandmann & D. Sondermann, 1994. "Closed Form Solutions for Term Structure Derivatives with Log-Normal Interest Rates," Discussion Paper Serie B 308, University of Bonn, Germany.
- 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.
- Rong Fan & Anurag Gupta & Peter Ritchken, 2003. "Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets," Journal of Finance, American Finance Association, vol. 58(5), pages 2219-2248, October.
- 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.
- Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330.
- 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.
- 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.
- Robert A. Jarrow, 2009. "The Term Structure of Interest Rates," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 69-96, November.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Helle Vinbaek Stenholt).
If references are entirely missing, you can add them using this form.