1 Department of Business Studies, Aarhus School of Business, Aarhus BSS, Aarhus University2 Finance Research Group, Aarhus School of Business, Aarhus BSS, Aarhus University3 unknown
This paper resolves the disagreement between Longstaff et al. [2001. Journal of Finance Economics 62, 39-66] and Andersen and Andreasen [2001. Journal of Financial Economics 62, 3-37] over the effectiveness of the common business practice of using best-fit single-factor term structure models to deduce exercise strategies of Bermudan swaptions. I examine the cost of using recalibrated single-factor models to determine the exercise strategy for Bermudan swaptions in a multifactor world. I show that single-factor exercise strategies applied in a multifactor world only give rise to economically insignificant losses. Furthermore, I find that the conditional model risk as defined in Longstaff et al. [2001. Journal of Finance Economics 62, 39-66] is statistically insignificant given the number of observations. Additional tests using the Primal-Dual algorithm of Andersen and Broadie [2004. Management Science 50(9)] indicate that losses found in Longstaff et al. [2001. Journal of Finance Economics 62, 39-66] cannot, as claimed, be ascribed to the number of factors.
Journal of Financial Economics, 2005, Vol 78, Issue 3, p. 651-684