I am trying to form a kind of unified perspective of how (vega) hedging an exotic with vanillas, or hedging a 'basket option' with vanillas will go wrong. So in particular, I want to be able to intuitively see how vega hedging a swaption with caplets can go wrong; since a swap rate is approximately a linear combination of forwards, which happen to be caplet underlyings.

I know the answer is kind of in the lines of 'no guarantee of being self financing' but I want to know in what market rate scenarios would it fail to be so.

Help appreciated!

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    $\begingroup$ My immediate thoughs of what can go wrong is that swaptions implied vol is not the same as the caplets implied vol. They can move separately and both move against you simultaneously. Think of a stocks analogy - you cannot really replicate S&P 500 implied vol from the implied vols of its component stocks. $\endgroup$ Jun 3 '20 at 12:42
  • $\begingroup$ Thanks for the response! Is that a theoretical observation or a market related observation? If the latter, then it kind of looks like a circular argument, inability to hedge vega allows independent implied vol movement, and vice versa. If theoretical, I think of swaption vol as sum of fwd variances plus covariances. So swaption vol should be determined by those completely, assuming correlations are stable. So I don't see how they move independently. $\endgroup$
    – Arshdeep
    Jun 3 '20 at 13:28
  • $\begingroup$ So trying to think about this a bit, the only reason one cannot 'lock in' swaption vol by trading in caplets may be because, say, the curve inverts, and the curve level remains the same. So the swaption moneyness is the same but the caplet moneyness' change, and therefore the vegas change, and therefore you need to rebalance... Does that sound OK? $\endgroup$
    – Arshdeep
    Jun 3 '20 at 13:34

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