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

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. © 2010 The Author(s).