Swap market model: theory and empirical evidence

Swap market model: theory and empirical evidence
Document type
Working Paper
Author(s)
Gan, Bing; Guan, Eric; Poon, Ser-Huang
Publisher
Manchester Business School
Date of publication
1 June 2008
Series
University of Manchester Business School Working Papers. No. 563
Subject(s)
Trends: economic, social and technology trends affecting business
Collection
Business and management
Material type
Reports

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This paper tests the co-terminal swap market model (SMM) pricing and hedging performance on Bermudan swaptions. To the authors' knowledge, the drift for SMM is derived explicitly for the first time here, and the procedures for calibration and simulation using a collection of forward swap rates are also shown in detail. The Longstaff-Schwartz least square method is used to approximate the early exercise decision in Bermudan swaption. By introducing individual parameters for volatility of each co-terminal forward swap rate, the model can match the market quoted European swaption price perfectly. It is noted that, for the SMM, one particular volatility formula may not be enough to
capture the term structure of different markets.

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