Hedging in the Possible Presence of Unspanned Stochastic Volatility: Evidence from Swaption Markets∗

This paper examines whether higher order multifactor models, with state variables linked solely to the full set of underlying LIBOR-swap rates, are by themselves capable of explaining and hedging interest rate derivatives, or whether models explicitly exhibiting features such as unspanned stochastic volatility are necessary. Our research shows that swaptions and even swaption straddles can be well hedged with LIBOR bonds alone. We examine the potential benefits of looking outside the LIBOR market for factors that might impact swaption prices without impacting swap rates, and find them to be minor, indicating that the swaption market is well integrated with the underlying LIBOR-swap market. JEL Classification: G12; G13; G19.