Factor dependence of Bermudan swaptions: fact or fiction?

Abstract

This paper investigates the effect of interest rate correlation in pricing and exercise of Bermudan swaptions. Investigating both Gaussian Markov models and Libor market models, we find that Bermudan swaption prices change only moderately (and in fact typically decrease slightly) when the number of factors in the underlying interest rate model is increased from one to two. We explain the rationale behind these results, and also demonstrate that exercise information generated within a best-fit one-factor model only leads to insignificant losses when properly applied in a two-factor model. Our results provide support for the standard Wall Street practice of using continuously re-calibrated one-factor models to price Bermudan swaptions, as long as calibration procedures are sufficiently comprehensive.