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Swap Market Model: Theory And Empirical Evidence

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Executive Summary

This paper tests the co-terminal Swap Market Model (SMM) pricing and hedging performance on Bermudan swaptions. To the knowledge, the drift for SMM is derived explicitly for the first time here, and the procedures for calibration and simulation using a collection of forward swap rates are also shown in detail. The Long staff-Schwartz least square method is used to approximate the early exercise decision in Bermudan swaption. By introducing individual parameters for volatility of each co-terminal forward swap rate, the model can match the market quoted European swaption price perfectly.

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