On Pricing and Hedging in the Swaption Market: How Many Factors, Really?∗

This article examines how the number of stochastic drivers and their associated volatility structures affect pricing accuracy and hedging performance in the swaption market. In spite of the fact that low dimensional one and two-factor models do not reflect historical correlations that exist among forward rates, we show that they are capable of accurately pricing swaptions as well as higher order multifactor models, across all expiry dates and over all underlying swap maturities. Effective out-of-sample pricing is necessary but not sufficient for good hedging. Indeed, regarding hedging, we show there are significant benefits in using multifactor models. This is true even if one accounts for the fact that fewer hedging instruments are required when single factor models are used to hedge swaptions. Our empirical findings have strong implications for the modeling and risk management of an array of actively traded derivatives that closely relate to swaptions. JEL Classification: G12; G13; G19.