Swap Market Model: Theory and Empirical Evidence

This paper tests the co-terminal swap market model (SMM) pricing and hedging performance onBermudan swaptions. To our knowledge, the drift for SMM is derived explicitly for the first timehere, and the procedures for calibration and simulation using a collection of forward swap rates arealso shown in detail. The Longstaff-Schwartz least square method is used to approximate the earlyexercise decision in Bermudan swaption. By introducing individual parameters for volatility of eachco-terminal forward swap rate, the model can match the market quoted European swaption priceperfectly. It is noted that, for the SMM, one particular volatility formula may not be enough tocapture the term structure of different markets. Hedging performance of the model is tested onEuro and USD European co-terminal swaption using a set of swaps as hedge instrument. Principlecomponent analysis (PCA) is adopted to capture the trend of the forward rates’ movement andabsolute mean of the PCA factors is used for the bumping of forward rate curve....