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Alternative models for hedging yield curve risk: An empirical comparison

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  • Carcano, Nicola
  • Dall'O, Hakim

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.

Suggested Citation

  • Carcano, Nicola & Dall'O, Hakim, 2011. "Alternative models for hedging yield curve risk: An empirical comparison," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2991-3000, November.
  • Handle: RePEc:eee:jbfina:v:35:y:2011:i:11:p:2991-3000
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    References listed on IDEAS

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    1. 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.
    2. 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.
    3. Robert C. Kuberek & Norman G. Pefley, 1983. "Hedging corporate debt with U.S. treasury bond futures," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 3(4), pages 345-353, December.
    4. 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.
    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. Fleming, Jeff & Whaley, Robert E, 1994. " The Value of Wildcard Options," Journal of Finance, American Finance Association, vol. 49(1), pages 215-236, March.
    7. 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 408-431, October.
    8. 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.
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    Cited by:

    1. Bessler, Wolfgang & Wolff, Dominik, 2014. "Hedging European government bond portfolios during the recent sovereign debt crisis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 33(C), pages 379-399.
    2. Laurini, Márcio Poletti & Ohashi, Alberto, 2015. "A noisy principal component analysis for forward rate curves," European Journal of Operational Research, Elsevier, vol. 246(1), pages 140-153.

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