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 risk-managed 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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Paper provided by EconWPA in its series Finance with number
0502008.
Pietersz, R. & Pelsser, A.A.J., 2005.
"A Comparison of Single Factor Markov-Functional and Multi Factor Market Models,"
Research Paper
ERS-2005-008-F&A Revision, 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 Uni.
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Find related papers by JEL classification: G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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