Alternative Models for Hedging Yield Curve Risk: An Empirical Comparison

38 Pages Posted: 6 Jul 2010

See all articles by Nicola Carcano

Nicola Carcano

University of Lugano

Hakim Dall'O

Swiss Finance Institute at the University of Lugano

Date Written: July 6, 2010

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.

Keywords: Yield Curve Risk, Interest Rate Risk, Immunization, Hedging.

JEL Classification: G11; E43

Suggested Citation

Carcano, Nicola and Dall'O, Hakim, Alternative Models for Hedging Yield Curve Risk: An Empirical Comparison (July 6, 2010). Swiss Finance Institute Research Paper No. 10-31, Available at SSRN: https://ssrn.com/abstract=1635291 or http://dx.doi.org/10.2139/ssrn.1635291

Nicola Carcano

University of Lugano ( email )

Via Sole 14
Ruvigliana, TN Ticino 6900
Switzerland

Hakim Dall'O (Contact Author)

Swiss Finance Institute at the University of Lugano ( email )

Via Buffi 13
Lugano, CH-6900
Switzerland
+41 58 666 4497 (Phone)

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