Reducing transaction costs for interest rate risk hedging with stochastic programming

Jörgen Blomvall and Johan Hagenbjörk

European Journal of Operational Research, 2022, vol. 302, issue 3, 1282-1293

Abstract: Traditional methods for hedging interest rate risk do not take transaction costs into account as they aim to eliminate all risk. We propose a two-stage stochastic programming model for hedging interest rate risk where transaction costs are weighed against portfolio variance. High-quality measurements of term structures enable us to extract the systematic risk factors and make precise estimates of the perceived transaction costs. The hedging cost is weighed against the reduction in portfolio variance by using an adjustable hedging parameter. The hedging procedure is simulated on a daily basis in a realistic setting over an out-of-sample period from 2002 to 2018, and the results are compared to traditional hedging methods through detailed performance attribution. Using second-order stochastic dominance, we show that the proposed method is preferred by all risk-averse investors.

Keywords: Finance; OR in banking; Risk management; Stochastic programming (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:302:y:2022:i:3:p:1282-1293

DOI: 10.1016/j.ejor.2022.02.004

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