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Alternative models for hedging yield curve risk: An empirical comparison

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  • Carcano, Nicola
  • Dall'O, Hakim
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    Abstract

    We test alternative models of yield curve risk 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 randomly varies from one model and hedging problem to the other. We show that accounting for the variance of modeling errors substantially reduces both hedging errors and transaction costs for all considered models. Additionally, it leads to much more stable weights in the hedging portfolios and - as a result - to more homogeneous hedging quality. On this basis, error-adjusted principal component analysis is found to systematically and significantly outperform alternative models.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 35 (2011)
    Issue (Month): 11 (November)
    Pages: 2991-3000

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    Handle: RePEc:eee:jbfina:v:35:y:2011:i:11:p:2991-3000

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Yield curve risk Interest rate risk Immunization Hedging;

    References

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    1. Carcano, Nicola & Foresi, Silverio, 1997. "Hedging against interest rate risk: Reconsidering volatility-adjusted immunization," Journal of Banking & Finance, Elsevier, vol. 21(2), pages 127-141, February.
    2. Fisher, Lawrence & Weil, Roman L, 1971. "Coping with the Risk of Interest-Rate Fluctuations: Returns to Bondholders from Naive and Optimal Strategies," The Journal of Business, University of Chicago Press, vol. 44(4), pages 408-31, October.
    3. Grieves, Robin & Marcus, Alan J. & Woodhams, Adrian, 2010. "Delivery options and convexity in Treasury bond and note futures," Review of Financial Economics, Elsevier, vol. 19(1), pages 1-7, January.
    4. Nawalkha, Sanjay K. & Soto, Gloria M. & Zhang, Jun, 2003. "Generalized M-vector models for hedging interest rate risk," Journal of Banking & Finance, Elsevier, vol. 27(8), pages 1581-1604, August.
    5. Dan Armeanu & Florentina-Olivia Balu & Carmen Obreja, 2008. "Interest Rate Risk Management using Duration Gap Methodology," Theoretical and Applied Economics, Asociatia Generala a Economistilor din Romania - AGER, vol. 1(1(518)), pages 3-10, January.
    6. Chambers, Donald R. & Carleton, Willard T. & McEnally, Richard W., 1988. "Immunizing Default-Free Bond Portfolios with a Duration Vector," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(01), pages 89-104, March.
    7. Fleming, Jeff & Whaley, Robert E, 1994. " The Value of Wildcard Options," Journal of Finance, American Finance Association, vol. 49(1), pages 215-36, March.
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