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.
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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:
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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)
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