Alternative Models For Hedging Yield Curve Risk: An Empirical Comparison

Nicola Carcano and Hakim Dall'o
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Nicola Carcano: Università della Svizzera Italiana and Bank Vontobel
Hakim Dall'o: Università della Svizzera Italiana and Swiss Finance Institute

No 10-31, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We develop alternative models for hedging yield curve risk and test them by hedging US Treasury bond portfolios through note/bond futures. We show that traditional implementations of models based on principal component analysis, duration vectors and key rate duration lead to high exposure to model errors and to sizable transaction costs, thus lowering the hedging quality. Also, this quality varies from one test case to the other, so that a clear ranking of the models is not possible. We show that accounting for the variance of modeling errors substantially reduces both hedging errors and transaction costs for all considered models. Also, this allows to clearly rank these models: error-adjusted principal component analysis systematically and significantly outperforms alternative models

Keywords: Yield Curve Risk; Interest Rate Risk; Immunization; Hedging (search for similar items in EconPapers)
JEL-codes: E43 G11 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2010-06
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1031

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