Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets
Weatherhead School of Management Finance Department Working Paper
34 Pages Posted: 15 Aug 2002
Date Written: August 13, 2002
This paper examines whether higher order multifactor models, with state variables linked solely to the full set of underlying LIBOR-swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the underlying LIBOR-swap market.
Keywords: Interest Rate Derivatives, Swaptions, Delta and Gamma Neutral Hedging, Unspanned Stochastic Volatility, Spanning
JEL Classification: G12, G13, G19
Suggested Citation: Suggested Citation