BFS 2002

Contributed Talk

Pricing and Hedging in the Swaption Market

Peter Ritchken, Rong Fan, Anurag Gupta

While models with one or two stochastic drivers might price swaptions as well as higher order models, when it comes to hedging, we show that models with three or four factors perform significantly better. We address whether these higher order multifactor models are by themselves capable of explaining and hedging derivative instruments or whether other factors, such as unspanned stochastic volatility, are sufficiently important to warrant explicit inclusion.