The compatibility of one‐factor market models in caps and swaptions markets: Evidence from their dynamic hedging performance

Abstract

AbstractThis study examines the dynamic hedging performance of the one‐factor LIBOR and swap market models in both caps and swaptions markets, using a procedure similar to the way that these models are used in practice. The effects of different calibration methods on model performance are investigated as well. The LIBOR market models and the swap market models are calibrated to the cross‐sectional Black implied volatilities for caps and swaptions respectively; the test is based on their effectiveness in hedging floors and swaptions that are not used in the calibration. We find that the LIBOR market models outperform the swap market models in hedging floors and perform as well as the swap market models in hedging swaptions. Our results also show that incorporating a humped volatility structure into these models does not significantly improve their hedging performance. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:109–130, 2008