Throwing away a billion dollars: the cost of suboptimal exercise strategies in the swaptions market

This paper studies the costs of applying single-factor exercise strategies to American swap options when the term structure is actually driven by mult iple factors. Using a multifactor string market model of the term structure , we find that even when single-factor models are recalibrated to match the market at every exercise date, the exercise strategies they imply can be s uboptimal. Based on estimates of notional amounts outstanding, the total pr esent value costs of following single-factor strategies could be several bi llion dollars. These results illustrate the importance of using well-specif ied term structure models. (C) 2001 Published by Elsevier Science S.A.