Swaption Portfolio Risk Management: Optimal Model Selection in Different Interest Rate Regimes

The authors formulate a risk-based swaption portfolio management framework for a profit-and-loss (P&L) explanation. They analyze the implication of using the right volatility backbone in the pricing model from a hedging perspective and demonstrate the importance of incorporating a stability and robustness measure as part of the calibration process for optimal model selection. They also derive a displaced-diffusion stochastic volatility model with a closed-form analytical expression to handle negative interest rates. Finally, they show that their framework is able to identify the optimal pricing model, which leads to a superior P&L explanation and hedging performance. TOPICS: Risk management, portfolio management/multi-asset allocation, derivatives, factor-based models Key Findings • A holistic, risk-based calibration framework allows one to select the optimal pricing model with superior P&L explanation performance. • A displaced-diffusion stochastic volatility model with closed-form expression provides a means to price swaptions efficiently under both positive and negative interest rate regimes while capturing the volatility backbone. • Using the Herfindahl index to measure the concentration of hedging performance, we show that the optimal model exhibits stability and robustness of model parameters, along with the economy of the explanatory power of daily P&L movement.