Improving Interest Rate Risk Hedging Strategies through Regularization

Daniel Mantilla-Garcia, Lionel Martellini, Vincent Milhau and Hector Enrique Ramirez-Garrido

Financial Analysts Journal, 2022, vol. 78, issue 4, 18-36

Abstract: The effectiveness of duration and convexity hedging strategies deteriorates in the presence of non-parallel shifts of the yield curve. In the absence of appropriate constraints, the extension of these strategies accounting for changes in the shape of the yield curve generates unstable weights and extreme leverage, leading to poor out-of-sample hedging performance. To address this conundrum, we recast the bond portfolio immunization problem as a multifactor optimization program with leverage constraints and weight regularization. These regularized immunization strategies offer a robust improvement in hedging performance and are particularly well-suited to secure future cash flow needs such as pension liabilities.

Date: 2022
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DOI: 10.1080/0015198X.2022.2095193

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