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

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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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  • Svenstrup, Mikkel, 2003. "On the Suboptimality of Single-Factor Exercise Strategies for Bermudan Swaptions," Finance Working Papers 02-24, University of Aarhus, Aarhus School of Business, Department of Business Studies.
    • Handle: RePEc:hhb:aarfin:2002_024
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    1. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
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