Managing swaption portfolio risk under different interest rate regimes

• Main Authors: NEO, Poh Ling, TEE, Chyng Wen
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2018
• Subjects: derivatives valuation; stochastic volatility models; interest rate markets; swaptions; risk management; portfolio management; pricing and hedging; Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/5977; https://ink.library.smu.edu.sg/context/lkcsb_research/article/6976/viewcontent/Managing_swaption_portfolio_risk_under_different_interest_rate_regimes.pdf
• Institution: Singapore Management University

Efficient risk managing of swaption portfolios is crucial in the hedging of interest rate exposure. This paper formulates a portfolio risk management framework under stochastic volatility models. The implication of using the right volatility backbone in the stochastic-alpha-beta-rho (SABR) model is analyzed. In order to handle negative interest rates, we derive a displaced-diffusion stochastic volatility (DDSV) model with closed-form analytical expression for swaption pricing. We demonstrate that the dynamics naturally allow for negative rates, and is also able to fit the market well. Finally, we show that choosing the right backbone in the DDSV model results in optimal hedging performance and P&L explanation.