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A Comparison of Single Factor Markov-functional and Multi Factor Market Models

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  • Raoul Pietersz

    (Erasmus University Rotterdam)

  • Antoon Pelsser

    (Erasmus University Rotterdam)

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 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.

Suggested Citation

  • Raoul Pietersz & Antoon Pelsser, 2005. "A Comparison of Single Factor Markov-functional and Multi Factor Market Models," Finance 0502008, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0502008
    Note: Type of Document - pdf; pages: 27
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Markov-functional model; market model; Bermudan swaption; terminal correlation; hedging; Greeks for callable products; smile;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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