Choice of Interest Rate Term Structure Models for Assets and Liability Management

Ser-Huang Poon, Eric Guan, Bin Gan, Aisha Khan

Research output: Working paper

Abstract

This paper compares the pricing and hedging performance of the LMM model against twospot-rate models, namely Hull-White and Black-Karasinski, and the more recent SwapMarket Model from an Asset-Liability-Management (ALM) perspective. In contrast toprevious studies in the literature, our emphasis here is on ALM and we use hedgingperformance on Bermudan swaptions to proxy risk management outcome of long-termmortgage loans. Our tests involve calibrating the four interest rate models to Europeanswaption prices for EURO and USD over the period February 2005 to September 2007. Thecalibrated models are then used to price and hedge a constant 11-year Bermudan swaptionportfolio using a series of interest rate swaps and a 1-year holding-revision period. Ourempirical results show that, the calibrated parameters of all four models are stable and theirpricing errors are small and comparable. No single model dominates in the pricing exercise.The hedging performance of all four models is similar for the Euro market. For the USDmarket, the short rate models perform marginally better than SMM and LMM. The HWmodel is marginally better than BK model in terms of model parameter stability and smallerpricing and hedging errors.
Original languageEnglish
Place of PublicationUK and USA
Number of pages57
Publication statusPublished - 2008

Publication series

NameManchester Business School Working Paper Series,
PublisherManchester Business School, http://ssrn.com/author=44637/

Keywords

  • Asset-liability management, Hull-White, Black-Karasinski, Libor Market Model, Swap Market Model, Bermudan swaptions

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