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The Journal of Derivatives

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Swaption Portfolio Risk Management: Optimal Model Selection in Different Interest Rate Regimes

Poh Ling Neo and Chyng Wen Tee
The Journal of Derivatives Winter 2019, 27 (2) 81-107; DOI: https://doi.org/10.3905/jod.2019.1.083
Poh Ling Neo
is a senior lecturer at the School of Business, Singapore University of Social Sciences in Singapore
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Chyng Wen Tee
is an associate professor at the Lee Kong Chian School of Business, Singapore Management University in Singapore
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Abstract

The authors formulate a risk-based swaption portfolio management framework for a profit-and-loss (P&L) explanation. They analyze the implication of using the right volatility backbone in the pricing model from a hedging perspective and demonstrate the importance of incorporating a stability and robustness measure as part of the calibration process for optimal model selection. They also derive a displaced-diffusion stochastic volatility model with a closed-form analytical expression to handle negative interest rates. Finally, they show that their framework is able to identify the optimal pricing model, which leads to a superior P&L explanation and hedging performance.

TOPICS: Risk management, portfolio management/multi-asset allocation, derivatives, factor-based models

Key Findings

  • • A holistic, risk-based calibration framework allows one to select the optimal pricing model with superior P&L explanation performance.

  • • A displaced-diffusion stochastic volatility model with closed-form expression provides a means to price swaptions efficiently under both positive and negative interest rate regimes while capturing the volatility backbone.

  • • Using the Herfindahl index to measure the concentration of hedging performance, we show that the optimal model exhibits stability and robustness of model parameters, along with the economy of the explanatory power of daily P&L movement.

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The Journal of Derivatives: 27 (2)
The Journal of Derivatives
Vol. 27, Issue 2
Winter 2019
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Swaption Portfolio Risk Management: Optimal Model Selection in Different Interest Rate Regimes
Poh Ling Neo, Chyng Wen Tee
The Journal of Derivatives Nov 2019, 27 (2) 81-107; DOI: 10.3905/jod.2019.1.083

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Swaption Portfolio Risk Management: Optimal Model Selection in Different Interest Rate Regimes
Poh Ling Neo, Chyng Wen Tee
The Journal of Derivatives Nov 2019, 27 (2) 81-107; DOI: 10.3905/jod.2019.1.083
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  • Article
    • Abstract
    • LITERATURE REVIEW
    • DATA AND EMPIRICAL ANALYSES
    • MODEL
    • MODEL SELECTION FOR OPTIMAL RISK MANAGEMENT
    • CONCLUSIONS
    • ADDITIONAL READING
    • ACKNOWLEDGMENTS
    • APPENDIX
    • REFERENCES
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