Deep Hedging Bermudan Swaptions

Abstract: Abstract This paper proposes a novel approach to Bermudan swaption hedging by applying the deep hedging framework to address limitations of traditional arbitrage-free methods. Conventional methods assume ideal conditions, such as zero transaction costs, perfect liquidity, and continuous-time hedging, which often differ from real market environments. This discrepancy can lead to residual profit and loss (P&L), resulting in two primary issues. First, residual P&L may prevent achieving the initial model price, especially with improper parameter settings, potentially causing a negative P&L trend and significant financial impacts. Second, controlling the distribution of residual P&L to mitigate downside risk is challenging, as hedged positions may become curve gamma-short, making them vulnerable to large interest rate movements. The deep hedging approach enables flexible selection of convex risk measures and hedge strategies, allowing for improved residual P&L management. This study also addresses challenges in applying the deep hedging approach to Bermudan swaptions, such as efficient arbitrage-free market scenario generation and managing early exercise conditions. Additionally, we introduce a unique "Option Spread Hedge" strategy, which allows for robust hedging and provides intuitive interpretability. Numerical analysis results demonstrate the effectiveness of our approach.