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A comparison of single factor Markov-functional and multi factor market models

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  • Raoul Pietersz
  • Antoon Pelsser

Abstract

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 riskmanaged 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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  • Raoul Pietersz & Antoon Pelsser, 2010. "A comparison of single factor Markov-functional and multi factor market models," Review of Derivatives Research, Springer, vol. 13(3), pages 245-272, October.
    • Handle: RePEc:kap:revdev:v:13:y:2010:i:3:p:245-272
    DOI: 10.1007/s11147-009-9050-5
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    More about this item

    Keywords

    Markov-functional model; Market model; Bermudan swaption; Terminal correlation; Hedging; Greeks for callable products; Smile; G13;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics

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