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I am considering some hedging strategy where portfolios of derivatives are built so that each portfolio is equivalent to a floating note, even if the instruments in the portfolio might be quite complicated, e.g. bermudean snowballs.

I plan to price numerically these portfolios in a forward LIBOR market model calibrated to swaption prices and I am wondering which accuracy I should expect on the total portfolio prices, i.e. on the pricing of floater notes.

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  • $\begingroup$ How do you plan to calibrate your LMM? If to the floaters then you should expect perfect accuracy. If not, why not? $\endgroup$ – Brian B Nov 27 '13 at 14:16
  • $\begingroup$ @BrianB It is a (forward) LMM calibrated to swaptions. I added these details in the question. $\endgroup$ – user40989 Nov 27 '13 at 15:09
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Calibrating to swaption prices would give you the right volatilities for your model, but you have to use the floating notes (or similar instruments, as swaps) in order to get the right drifts. In any case, your model have to be able to exactly replicate the floating notes prices in order to be considered a valid model, and you can feel comfortable to use it with more exotic products.

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  • $\begingroup$ The implementaiton I am working on uses a rolled over bond as nominal and simulates with an Euler scheme. So the term structure is used to initialise the drifts, but after time 0 the whole dynamic is governed by the volatility and the correlation structures, so it is not clear to me how I can “reinject” the term structure in this model. Your second statement confirms what I thought and I now have to advocate this above me! $\endgroup$ – user40989 Dec 5 '13 at 7:20

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