Alternative Models for Hedging Yield Curve Risk: An Empirical Comparison

Abstract

This chapter extends the results presented in Chapter 2 to further interest rate hedging models. We present the results of explicitly accounting for the variance of the model errors displayed by each zero rate. We find out that the reduction in both the hedging errors and the transaction costs is substantial: the errors are reduced on average by 17% for the PCA model, by 39% for the KRD model and by 53 % for the DV model. What is perhaps more important is that the error adjustment makes the optimal weights of the hedging strategies far more stable. Also, we do find that the error-adjusted PCA model systematically outperforms all alternative models. Finally, this chapter shows that bond futures can effectively be used to hedge the yield curve risk of a bond portfolio.