Hedging in bond markets by the Clark-Ocone formula
Nicolas Privault, Timothy Robin Teng
TL;DR
This paper develops a method for bond market hedging using the Clark-Ocone formula, providing a mathematically rigorous approach that is applied to interest rate derivatives and compared to traditional delta hedging methods.
Contribution
It introduces a novel hedging framework based on martingale representation and the Clark-Ocone formula in bond markets, enhancing the theoretical tools for interest rate derivative hedging.
Findings
Effective hedging of swaptions demonstrated
Comparison shows advantages over delta hedging in certain models
Framework applicable to various interest rate derivatives
Abstract
Hedging strategies in bond markets are computed by martingale representation and the Clark-Ocone formula under the choice of a suitable of numeraire, in a model driven by the dynamics of bond prices. Applications are given to the hedging of swaptions and other interest rate derivatives, and our approach is compared to delta hedging when the underlying swap rate is modeled by a diffusion process.
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