Factor Dependence of Bermudan Swaption Prices: Fact or Fiction?

Abstract

This paper investigates the effect of interest rate correlation in the pricing of Bermudan swaptions. Investigating both Gaussian Markov models and Libor Market models, we find that Bermudan swaption prices depend only weakly on the number of factors in the underlying interest rate model. Moreover, we find that prices of standard Bermudan swaptions typically decrease slightly in the number of factors, primarily a consequence of effects on the time evolution of volatility induced by calibration of the model dynamics. Our findings are markedly different from those of Longstaff, Schwarz, and Santa-Clara (1999) who conclude that single-factor interest rate models significantly undervalue Bermudan swaptions. We argue that the conclusions of Longstaff, Schwarz, and Santa-Clara are due to non-standard choices of model dynamics and calibration methodology. Our study highlights the importance of using a reasonable set of calibration instruments when applying and comparing interest rate models.