Finance Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: In this paper we examine the cost of using recalibrated single-factor

models to determine the exercise strategy for Bermudan swaptions in a

multi-factor world. We demonstrate that single-factor exercise strategies

applied in a multi-factor world only give rise to economically insignificant

losses. Furthermore, we find that the conditional model risk as defined

in Longstaff, Santa-Clara & Schwartz (2001), is statistically insignificant

given the number of observations. Additional tests using the Primal-Dual

algorithm of Andersen & Broadie (2001) indicate that losses found in

Longstaff et al. (2001) cannot as claimed be ascribed to the number of

factors. Finally we find that for valuation of Bermudan swaptions with

long exercise periods, the simple approach proposed in Andersen (2000)

is outperformed by the Least Square Monte Carlo method of Longstaff &

Schwartz (2001) and, surprisingly, also by the exercise strategies from the

single-factor models.

Keywords: Bermudan swaption; American option; Least Square Monte Carlo; Libor Market Model; Model Risk; Model Calibration

38 pages, May 9, 2003

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