Implications for Hedging of the Choice of Driving Process for One-Factor Markov-Functional Models

Joanne E. Kennedy, Duy Pham
2011 Social Science Research Network  
In this paper, we study the implications for hedging Bermudan swaptions of the choice of the instantaneous volatility for the driving Markov process of the one-dimensional swap Markov-functional model. We find that there is a strong evidence in favour of what we term "parametrization by time" as opposed to "parametrization by expiry". We further propose a new parametrization by time for the driving process which takes as inputs into the model the market correlations of relevant swap rates. We
more » ... ow that the new driving process enables a very effective vega-delta hedge with a much more stable gamma profile for the hedging portfolio compared with the existing ones.
doi:10.2139/ssrn.1972932 fatcat:r4c5ilwejneljkobvl43k4p7mi