A comparison of single factor Markov-functional and multi factor market models |
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Authors: | Raoul Pietersz Antoon Pelsser |
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Institution: | 1.Product Development Group, Quantitative Analytics, Global Markets,ABN AMRO Bank,Amsterdam,The Netherlands;2.Departments of Finance and Quantitative Economics,Maastricht University,Maastricht,The Netherlands |
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Abstract: | We compare single factor Markov-functional and multi factor market models and the impact of their correlation structures on
the 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 use the constant exercise 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 the constant exercise method enables proper functioning of market models as risk-management tools. |
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