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Alternative Models For Hedging Yield Curve Risk: An Empirical Comparison

Author

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  • Nicola CARCANO

    (Università della Svizzera Italiana and Bank Vontobel)

  • Hakim DALL'O

    (Università della Svizzera Italiana and 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

Suggested Citation

  • Nicola CARCANO & Hakim DALL'O, 2010. "Alternative Models For Hedging Yield Curve Risk: An Empirical Comparison," Swiss Finance Institute Research Paper Series 10-31, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1031
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    Keywords

    Yield Curve Risk; Interest Rate Risk; Immunization; Hedging;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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