Dynamic hedging of swaptions:

Abstract: This thesis shows that strictly following the Black model exposes the user to unexpected risk when hedging swaptions. The results emphasize that the strike offset and time to expiry have explanatory power for the hedging performance of the Black model. Furthermore, this thesis examines the impact of the volatility misestimation, arising due to the underlying assumption of constant volatility in the Black model, on delta hedging errors from a dynamic hedging strategy of swaptions. For this purpose, different selection criteria for the volatility are employed. The results from the hedging performance show that choosing a volatility that corresponds to the market implied volatility for the swaptions hedged is superior to a selection criterion that not violates the assumption of the model. Further, the thesis concludes that choosing an implied volatility that corresponds to a more liquid swaption improves the hedging performance. Also, the thesis examines whether the hedging performance can be improved by employing a model that has a more accurate volatility structure. For this purpose the constant elasticity of variance (CEV) model is employed. The results indicate that by employing a model of a different diffusion class, the hedging performance of the dynamic hedging study can be improved.