Swaption portfolio risk management: Optimal model selection in different interest rate regimes

• Main Authors: NEO, Poh Ling, TEE, Chyng Wen
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2019
• Subjects: derivatives valuation; interest rate markets; swaptions; risk management; portfolio management; pricing and hedging; stochastic volatility models; SABR model; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/6404; https://ink.library.smu.edu.sg/context/lkcsb_research/article/7403/viewcontent/Swaption_Portfolio_Risk_Management_sv.pdf
• Institution: Singapore Management University

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