The cost of using misspecified models to exercise and hedge American options on coupon bearing bonds

Welihockyj, Alexander

The cost of using misspecified models to exercise and hedge American options on coupon bearing bonds

Master Thesis

2016

Publisher

University of Cape Town

Department

Division of Actuarial Science

Faculty

Faculty of Commerce

Abstract

This dissertation investigates the cost of using single-factor models to exercise and hedge American options on South African coupon bearing bonds, when the simulated market term structure is driven by a two-factor model. Even if the single factor models are re-calibrated on a daily basis to the term structure, we find that the exercise and hedge strategies can be suboptimal and incur large losses. There is a vast body of research suggesting that real market term structures are in actual fact driven by multiple factors, so suboptimal losses can be largely reduced by simply employing a well-specified multi-factor model.

Keywords

Mathematical Finance

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