Posted by
Luca Berardi on
Feb 24, 2005; 2:52am
URL: http://quantlib.414.s1.nabble.com/Possible-problem-on-bermuda-swaptions-2-tp3621p3623.html
>Luca,
> no, that is correct. The Hull-White model allows negative rates
>(I'm told it's a known weakness of the model) resulting in discounts
>greater than 1 in some regions of the tree.
I do agree. In my posting #2 I didn't make myself very clear on
this. I hope I was more precise in posting #3. The hull-white model
gives the short rate as the sum of a ornstein-uhlenbeck diffusion
process and a fitting curve function...Hence, it's not a matter
whether the short rate can be negative (this is always theoretically
possible), but if the short rate can be negative for the tree created
with a given set of parameters for the hull-white model (spatial step,
sigma and reverse speed and the fitting function). Trying to
investigate all the possible sources of the mispricing I was afraid
that the tree was not built correctly (but now I realize I cannot find
any differences between the hull-white tree construction in releases
0.3.7 and 0.3.8 ...am I right?) ...but -as you're pointing out- this
is not the problem.
>Instead, the problem in the new release seems to be some date
>synchronization: namely, due to date adjustment it may happens that an
>exercise date is one or two days earlier than a fixed-coupon payment. This
>leads to incorrect pricing as the underlying of the option will include
>such payment---which it shouldn't. I'm testing a patch to fix the issue;
>I should be able to make it available in a few hours.
This is an extremely interesting issue, and I had the chance to
discuss it thoroughly with a trader recently. He explained to me that
the very successive cashflow of the underlying swap after the exercise
date should NEVER be considered in the bermuda swaption pricing. So
the correct behavior would be alwasy to disregard this cashflow:
unlike bonds, swaps do not have accrued interests to pay for.
In particular if the exercise date is also a payment date, the current
payment is discarded.
Ciao,
Luca
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