Swiss Finance Institute Research Paper Series N10 31

Alternative Models For Hedging Yield Curve Risk: An Empirical Comparison

Nicola CARCANO
Universit della Svizzera Italiana and Bank Vontobel

Hakim DALL'O
Universit della Svizzera Italiana and Swiss Finance Institute

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ALTERNATIVE MODELS FOR HEDGING YIELD CURVE RISK: AN EMPIRICAL COMPARISON 1 NicolaCarcano UniversitdellaSvizzeraItaliana,LuganoandBankVontobel,Zurich. nicola.carcano@sunrise.ch.ViaSole14,CH6977Ruvigliana. HakimDallO UniversitdellaSvizzeraItaliana,LuganoandSwissFinanceInstitute. hakim.dallo@usi.ch.Telephone:00410586664497Fax:00410586664734 ViaBuffi13,CH6900Lugano. 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, durationvectorsandkeyratedurationleadtohighexposuretomodelerrorsandto sizabletransactioncosts,thusloweringthehedgingquality.Also,thisqualityvaries fromonetestcasetotheother,sothataclearrankingofthemodelsisnotpossible. Weshowthataccountingforthevarianceofmodelingerrorssubstantiallyreduces both hedging errors and transaction costs for all considered models. Also, this allows to clearly rank these models: erroradjusted principal component analysis systematicallyandsignificantlyoutperformsalternativemodels. Keywords:Yieldcurverisk,interestraterisk,immunization,hedging. JELcodes:G11;E43
1

We are grateful to Robert R. Bliss for having allowed us to use his yield curve estimates and to Ray Jireh and Daniel Grombacher from the CME for having provided us with the relevant data underlying the bond future contracts. All errors or omissions should only be charged to the authors.

1. Introduction Wedefineyieldcurveriskastheriskthatthevalueofafinancialassetmightchange duetoshiftsinoneormorepointsoftherelevantyieldcurve.Assuch,itrepresents oneofthemostwidelyspreadfinancialrisksimpactingaverydiversifiedrangeof entities: not only financial institutions, like banks (both central and private), insurancecompanies,portfoliomanagers,andhedgefunds,butalsopensionfunds, real estate as well as many other industrial companies. Generalizing, we may say that each institution having to match future streams of assets and liabilities is exposeduptoacertainextenttoyieldcurverisk. The simplest way to cope with yield curve risk is to match positive with negativecashflowsasmuchaspossible.Thisapproachof cashflow matching isnot onlytheoreticallystraightforward,butalsoveryeffectiveinminimizingyieldcurve risk.Unfortunately,thedatesandtheamountsoffuturecashflowsareoftensubject to constraints in practice, so that implementing an accurate cashflow matching mightnotbepossible. Whencashflowmatchingisnotpossible,socalled immunizationtechniques areemployedtomanageyieldcurverisks.Thesetechniqueshavethegoalofmaking the sensitivity of assets and liabilities to yield curve changes as much as possible similar to each other. The key idea behind these techniques is that if assets and liabilities react in a similar way to a changein the yield curve, the overall balance sheetwillnotbelargelyaffectedbythischange. Originally,academiciansandpractitionersfocusedontheconceptofduration firstly introduced by Macaulay (1938) for implementing immunization

techniques.Durationrepresentsthefirstderivativeofthepriceyieldrelationshipof a bond and was shown to lead to adequate immunization for parallel yield curve shifts 1 . Accordingly, we can claim that the first models relying on duration were targetinggenericinterestrateriskandnotreallyyieldcurverisk,sincethedifferent pointsoftheyieldcurvewerenotallowedtomoveindependentlyfromeachother. Thefirststeptomovefromgenericinterestraterisktoyieldcurveriskwas made with the introduction of the concept of convexity (see, for example, Klotz (1985)).Convexityisrelatedtothesecondderivativeofthepriceyieldrelationship ofabond.However,theimpactofinterestratechangestakingplaceoverafewdays orweeksisnormallywellapproximatedbyduration.Accordingly,theimportanceof convexityiscommonlynotrelatedtoitsaddedvalueinthedescriptionoftheprice yieldrelationship.AshighlightedbyBierwagetal.(1987)andrecentlyconfirmedby Hodges and Parekh (2006), this importance is due to the fact that immunization strategiesrelyingondurationandconvexitymatchingareconsistentwithplausible twofactorprocessesdescribingnonparallelyieldcurveshifts. Later research took the argument supporting duration and convexity matchingevenfurther:socalled Msquareand Mvectormodelswereintroducedby Fong and Fabozzi (1985), Chambers et al. (1988), and Nawalka and Chambers (1997). Similarly as for convexity, most of these models relied on the observation that furtherorder approximations of the priceyield relationship lead to immunizationstrategieswhichareconsistentwithmultifactorprocessesaccurately describingactualyieldcurveshifts.Wewillidentifythisclassofmodelsas duration vector(DV)models.AnaccuratereviewofthemisgiveninNawalkaandet.(2003),

who also introduce a generalization of the DV approach identified as generalized durationvector(GDV). A parallel development of immunization models relied on a statistical descriptionofthefactorsunderlyingyieldcurveshifts.Thisdescriptionwasbased on a technique known as principal component analysis (PCA). PCA identifies orthogonal factors explaining the largest possible proportion of the variance of interestratechanges.LittermanandScheinkman(1988)showedthataPCArelying on 3 components allows to capture the three most important characteristics displayed by yield curve shapes: level, slope, and curvature. Accordingly, immunizationmodelsmatchingthesensitivityofassetsandliabilitiestothesethree componentsshouldleadtohighqualityhedging. Athirdclassofwidelyusedimmunizationmodelsreliesontheconceptofkey rate duration (KRD) introduced by Ho (1992). These models explain yield curve shiftsbasedonacertainnumberofpointsalongthecurvethekeyratesandon linearapproximationsbasedontimetomaturityfortheremainingrates. Yieldcurvehedgingtechniquesusedinpracticeveryoftenrelyononeofthe threeabovementionedclassesofmodels.However,wearenotawareofaconclusive evidenceontherelativeperformanceofthesethreeapproaches 2 .Moreover,several studies performing empirical tests of these hedging models reported puzzling results. Particularly, models capable to better capture the dynamics of the yield curve were not always shown to lead to better hedging. This was the case of the volatilityandcovarianceadjustedmodelstestedbyCarcanoandForesi(1997)and of the 2component PCA tested by Falkenstein and Hanweck (1997) which was

foundtoleadtobetterimmunizationthanthecorresponding3componentPCA.As a result, the key question about the best model to use in order to minimize yield curveriskhasnotfoundaconclusiveanswer,yet. Carcano(2009)testedamodelofPCAhedgingwhichcontrolstheexposure tomodelerrors.Hefoundthatbyintroducingthisadjustment3componentPCA doesleadtobetterhedgingthan2componentPCA,astheorywouldsuggest.Onthis basis, he claimed that random changes in the exposure to model errors might be responsible for the lack of conclusiveness displayed by previous empirical tests of alternativehedgingmodels. The goal of this paper is to provide relevant empirical evidence for identifyingthebestmodeltominimizeyieldcurverisk.Ourexpectationwasthatthe exposuretomodelerrorsplaysacrucialroleindeterminingtheperformanceofthe alternative models. Once an adjustment for this error is introduced, the quality of thetestedmodelsmainlydependsonhowwelltheunderlyingfactormodelcatches the actual dynamics of the yield curve. Accordingly, we extended all three mainstream immunization approaches in order to account for model errors and compared them among themselves and with their traditional implementations whichignoremodelerrors. Wereliedonpreviousevidencethatthreefactorsaresufficienttoexplainthe vast majority of the yield curve dynamics and tested only threefactor models. Accordingly, we expected the quality of the resulting erroradjusted hedging strategiestobecomparable.ThePCAmodelisconstructedinawaytoexplainthe largestpossiblepartofthevarianceofyieldcurveshiftsbasedonthreeorthogonal

factors.Accordingly,wesuspectedthatonceweaccountformodelerrorexposure thismodelwouldslightlyoutperformthealternativemodels. WetestedthealternativestrategiesonaportfolioofUSTreasurybondsand noteshedgedbyfourUSTreasurynoteandbondfuturecontracts.Ourexpectations havebeenconfirmedbytheresultsofthesetests.Eventhoughitisnotpossibleto clearly rank the models based on their traditional implementations, the approach relying on PCA consistently outperforms the other approaches when the error adjustment is introduced. Additionally, this adjustment is shown to add very significantvaluetoallthreetestedapproaches. The remainder of the paper is organized as follows: section 2 presents the hedging models we are going to test and their theoretical justification. Section 3 describes our dataset and testing approach. Section 4 reports our results, both on the full sample as well as on three subsamples, while Section 5 concludes and indicatessomepossibledirectionsforfutureresearch. 2. TheHedgingMethodology 2.1Thesensitivityofbondandfutureprices Weconsidertheproblemofimmunizingariskfreebondportfoliowhichattime t hasavalue Vt byidentifyingtheoptimalunderlyingvalue ytobeinvestedineach of the four US Tnote/Tbond futures (the 2year, the 5year, the 10year, and the 30year contracts). We group the cash flows of the bond portfolio and of the cheapesttodeliver bonds underlying the futures in n time buckets. Following the

mostcommonapproachtothisimmunizationproblemasinMartelliniandPriaulet (2001),weimposethesocalledselffinancingconstraint:

y =1

y ,t

H t = Vt

(1.)

The latter constraint implies that the market value of the portfolio to be hedged mustbeequaltothemarketvalueofthehedgingportfoliowhenthelatterconsists ofbondsortothemarketvalueoftheunderlyingbondswhenthelatterconsistsof derivativecontracts(likeinourcase).Inpractice,theamountstobeinvestedinthe hedgingportfolioareoftenconstrained,eventhoughtheformoftheseconstraints can differ from the last equation. Accordingly, we felt that including a constraint wouldmakeourempiricaltestsmorerealistic. We intend to analyze the quality of alternative hedging models on a very short hedging horizon, ideally tending to zero. For practical reasons, we set this hedging horizon to one month. This choice was motivated by the fact that many institutional investors and portfolio managers do have a time horizon of 1 to 3 months, when they set up their hedging strategies. After this period, they mostly reconsiderthewholehedgingproblemanddetermineanewstrategy. Themarketriskfortheportfoliotobehedgedcomesfromunexpectedshifts inthecorrespondingcontinuouslycompoundedzerocouponriskfreerates R(t,Dk), where Dkindicatesthedurationandmaturityofthecorrespondingtimebucket.We assume,forsimplicity,thatallratesaremartingales:thatis, E[dR(t,Dk)]=0forevery kandt.

Approximatingthedynamicsofthetermstructurethroughalimitednumber of factors results in a difference between the modeled and actual dynamics of interestrates,the model error.Forageneric3factormodelofthetermstructureof interest rates, we can describe the dynamics of the zerocoupon riskfree rate R(t,Dk)ofmaturityDkas:
dR (t , Dk ) clk Ft l + (t , Dk )
l =1 3

(2.)

where Flt represents the change in the lth factor between time t and t+1, clk representsthesensitivityofthezerocouponrateofmaturity Dktothischange,and representsthemodelerror. Asreportedinseveralpapers,likeHodgesandParekh(2006),theimpactof monthlyratechangesonthepriceofazerocouponbondcanbewellapproximated byitsduration.Accordingly,wewillfollowthissimplifyingapproach. Estimating the sensitivity of future prices to changes in zero rates is significantly more complex. This is due to the fact that as illustrated by Fleming andWhaley(1994)futurecontractsembed4typesofoptions.Thefirstoptionisa qualityoptionthatpermitstheshortpositiontodeliverthecheapestbond(theso calledCheapesttoDeliverorCTD)tothelongposition.Theotherthreeoptionsare defined time options 3 . So far, both academicians and practitioners working on immunization have focused on the first option, considering the possible impact of thetimeoptionsonoptimalhedgingstrategiestobenegligible.Wewillfollowthe sameapproachandrestrictournextconsiderationstothequalityoption.

In the past, researchers implementing hedging strategies through note and bondfuturesattemptedtosimplifytheproblem.Oneapproachhasbeentocalculate thesensitivityofthefuturesthroughstandardregressionanalysis(examplesofthis approach can be found in Kuberek and Norman (1983) and more recently in CollinDufresneet.al(2001)andinEltonetal.(2001)).Suchanapproachimplicitly assumesthatthesensitivityofthefuturepriceincludingthevalueofthequality optionisconstantovertime.Intendingtotesthighqualityhedgingstrategieson US Treasuries and knowing that the sensitivity of the future price varies significantlywiththeunderlyingCTDbond,wedecidednottofollowthisapproach. Asecondsimplifyingapproachmadetheembeddedqualityoptionlesscomplex thanitreallyis.Forexample,GrievesandMarcus(2005)assumedthatthisoption can be represented as a switching option between only two bonds. Unfortunately, latestresearchhasshownthatthissimplificationistoocrudetoaccuratelydescribe futurepricesensitivity(see,forexample,Henrard(2006)andGrievesetal.(2010)). As a result, numerical procedures based on arbitragefree term structure models are currently recommended when an accurate evaluation of the quality optionisneeded.However,weintendtominimizeyieldcurveriskbasedonthree factorPCA,DV,andKRDmodels.Accordingly,wewouldneedtorelyonmultifactor term structure models capable of producing stable and robust estimates of the sensitivityoffuturepricestothesefactors.Thedevelopmentofamodelwiththese characteristicsgoesbeyondthescopeofthispaperandislefttofurtherefforts.Our goalhereistocomparetraditionalanderroradjustedversionsofthethreehedging modelsinthesimplestpossibleway,sotomakeourresultsasgeneralaspossible.

Ourwayoutofthisdilemmareliesontheobservationmadeamongothers by Rendleman (2004) and Grieves et al. (2010). They show that the value of the delivery option has a very low impact on hedging strategies based on the next expiringfuturecontract,whenyieldsarenot too closetothenotionalcouponofthe futurecontract."Tooclose"isnormallydefinedasanabsolutedistancenotgreater than0.5%1%.Wewillshowlateronthatforthevastmajorityofoursample yields are not too close to the notional coupon. Accordingly, we will estimate the sensitivityofthefuturepriceignoringthedeliveryoptionandperformasubsample analysis to show if and how our results vary when yields are too close to the notionalcoupon. Within this framework, the quoted future price FP can be represented by the followingexpression:

FPt =

1 n cf CTD ,k R (t , Ds )Ds e AI CTD ,s R (t , Dk ) Dk CFCTD k = s +1 e

(3.)

where CFindicatestheConversionFactor, cfCTD,kindicatesthecashflowpaidbythe cheapesttodeliver bond at time k, and AICTD,s represents the accrued interests of thecheapesttodeliverbondontheexpirationdatesofthefuturecontract.Theonly cashflows of this bond which are relevant for the valuation of the future contract aretheonesmaturingaftertheexpirationdates. Approximating the effect of rate changes on the price of a zero bond by its duration, the percentage sensitivity of the future price to these changes can be expressedas:

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FP t FP Dk eR(t ,Ds )Ds cfCTD,k t DkCTD,k ,t R(t ,Dk ) Dk FP R(t, Dk ) t CF CTD e

forallratesmaturingafterthefuturecontract(i.e.:k>s)and

(4.)

FP t n FP D e R(t ,Ds )Ds n cfCTD,k t s = D s CTD,k ,t DsCTD,s ,t e R(t ,Dk )Dk CF R(t , Ds ) FP k =s +1 t CTD k =s +1

(5.)

forthezeroratewithmaturityequaltotheexpirationofthefuturecontract,where CTD,k, represents the percentage of the CTD future price related to the CTD cash flowwithmaturity kandisdefinedbasedonthelasttwoequations.Thesensitivity of the future price to changes in zero rates maturing before the future contract is zero,whichimplies:CTD,k,t=0forallk<s. 2.2Thedevelopmentofthehedgingequations Giventheapproachtoestimatethesensitivityofbondandfuturepricestozerorate changes described in the previous chapter, we approximate the total unexpected returnprovidedbythecombinationofthetwoportfoliosVandHasfollows:

t y ,t dR (t , Dk )Dk y ,k ,t + dR (t , Dk )Dk Ak ,t
y =1 k =1 k =1

(6.)

whereAiindicatesthepresentvalueofthebondportfoliocashflowsincludedinthe ithtimebucket.AsinCarcano(2009),weassumethattheerrortermsoftwozero rates of different maturity are independent from each other. Additionally, we assumethattheerrortermofthezerorateofmaturity Dk isindependentfromthe fittedvalues cl Ft l ofallconsideredzerorates,includingthezerorateofmaturity
l =1 3

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Dk 4 .OnthisbasisandrelyingonthedefinitionofdR(t,Dk)givenin(2.),theexpected squaredvalueoftheunexpectedreturncanbeapproximatedby:

Et [ t ]
n

4 4 3 3 l Dk Ak,t y,t Dky,k,t Dv Av,t y,t Dvy,v,t Et clk Ft chvFt h + k =1 v=1 y=1 y=1 h=1 l =1 n n 2 2

4 + (t, Dk ) D A k k,t y,t Dky,k,t k =1 y=1

(7.)

IfweconstructtheLagrangianfunctionas:

M +1 L ( t , t ) = E t2 t y ,t H t y = 1

( )

(8.)

andwesetitsfirstderivativesequaltozero,weobtaintheselffinancingconstraint (1.)andthefollowing4equationsforeachfuturejincludedinthehedgingportfolio:
3 n n 4 3 2 2j,v,t Dv Dk Et clk Ftl chvFth + (t, Dk ) Dk2j,k,t y,ty,k,t Ak,t = t (9.) h=1 k=1 v=1 l=1 y=1

Theproofofthesecondorderconditionoftheminimizationcanbeobtained analogously as in Carcano (2009). For each erroradjusted hedging strategy, the optimalweights ytobeinvestedineachfuturehavebeencalculatedbasedonthe lastsetofequations.ForthePCAmodel,thelastequationcanbesimplifiedrelying ontheindependencyamongtheprincipalcomponentsasfollows:
n 3 n 2 j,v,t Dv Dk clk clv Et Ftl l =1 k =1 v=1

[( ) ]+ (t, D ) D
2 2

2 k

4 j ,k ,t y,t y,k ,t Ak ,t = t y=1

(10.)

Itcanbeeasilyseenthatthetraditionalversionofthesemodelsrepresentsa specialcaseoftheirerroradjustedversionwhenthevolatilityofthemodelerrors is set equal to zero. We will now briefly recall the hedging equations for the

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traditionalversionoftheanalyzedmodelsandthecorrespondingprocessesofzero ratechanges.Thecommonideabehindthetraditionalhedgingequationsisthatthe sensitivity of the portfolio to be hedged to the three risk factors must be exactly replicatedbythesensitivityofthehedgingportfolio. In the case of the PCA model, the factors included in equation (2.) are the threeprincipalcomponents.Inadditiontotheselffinancingconstraint,thehedging equationsforthetraditionalversionofthismodelare:

y,ty,k,t c1k Dk = Ak,t c1k Dk

k =1 y=1 n 4 k =1 n

y,ty,k,t c2k Dk = Ak,t c2k Dk

k =1 y=1 n 4 k =1 n

(11.)

k =1 y=1

y,t

y,k ,t c3k Dk = Ak ,t c3k Dk

k =1

Thefactors,factorsensitivities,anderrortermshavebeendirectlyobtainedbythe applicationofthePCAmethodology. FortheDVmodel,werefertoChambersetal.(1988).Theprocessunderlying thismodelcanbeconsideredasaspecialcaseofthegenericprocess(2.),wherethe threesensitivityparameters clkhavebeensetequaltorespectively1, Dk , and Dk2. Inadditiontotheselffinancingconstraint,thetraditionalversionoftheDVmodel leadstothefollowingsystemofhedgingequations:

y,ty,k,t Dk = Ak,t Dk
k=1 y=1 n 4 k=1 n

y,ty,k,t Dk2 = Ak,t Dk2

k=1 y=1 n 4 k=1 n

(12.)

k=1 y=1

y,t

y,k,t D = Ak,t D
3 k k=1

3 k

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Thelinear3factorprocessofzeroratechangeswhichisconsistentwiththismodel andminimizesthemodelerrorisrepresentedby:

dR (t , D k ) F t 1 + F t 2 D k + F t 3 D k2 + (t , D k ) (13.)
where the factors and the error terms have been estimated applying the ordinary least square technique to the changes in all considered zero rates between time t andt+1.ItisvisiblethatifwemultiplyeachtermofthelastequationbyDKinorder toestimatethesensitivityofthebondpricetothezeroratechange,weobtainthe overallsensitivitytothefactorchangesonwhichtheequationsin(12.)arebased. A review of the DV methodology is given in Nawalkha et al. [2003] who proposeandtestageneralizationofit.Theyfoundoutthatforshortimmunization horizons like the one we are going to assume a GDV model leading to lower exponentsfor Dkthanin(13.)leadstobetterimmunization.Theysuggestthatthe reason for this result might be that lower exponents are consistent with mean reverting processes leading to higher volatility for shortterm rates than for long termrates(acharacteristicconsistentlydisplayedbyyieldcurveshifts). Particularly, they suggest a model which results in setting the three sensitivityparametersofexpression(2.)equaltorespectivelyDk0.75,Dk0.5,andDk
0.25.Thisleadstothefollowingsystemofhedgingequations:

y,ty,k,t Dk0.25 = Ak,t Dk0.25

k =1 y=1 n 4 k =1

y,ty,k,t Dk0.5 = Ak,t Dk0.5

k =1 y=1 n 4 k =1 n

(14.)

k =1 y=1

y,t

y,k ,t D

0.75 k

= Ak ,t D
k =1

0.75 k

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Followingthesamereasoningdescribedabove,thelinear3factorprocessof zeroratechangeswhichisconsistentwiththelastsetofequationsandminimizes themodelerrorisrepresentedby: dR (t , D k ) Ft1 Ft 2 Ft 3 + + + (t , D k ) (15.) D k0.75 D k0.5 D k0.25

wherethefactorsandtheerrortermshavebeenestimatedlikeintheDVmodel. ItshouldbehighlightedthatNawalkhaet.[2003]testedaversionofDVand GDVmodelsincludingaminimizationofthesquaredvaluesoftheweights y.This was motivated by an excess of the hedging instruments over the hedging constraints.Thisdoesnotapplytoourcase,sincewehavefourhedgingconstraints (e.g.: for the GDV model, the three constraints reported under (14.) and the self financing constraint) and four hedging instruments (the four bond/note future contractsexistingatthebeginningofourdataset). FortheKRDmodel,werefertoHo(1992).Theresultingprocessofzerorate changescanbedescribedas:
KRD dR (t , Dk ) clk Ft l + (t , Dk ) l =1 3

(16.)

where in this case the factor Fl represents the lth key zero rate change and clk represents the sensitivity of the zerocoupon rate of maturity Dk to this change whichhasbeendefinedfollowingNawalkhaetal.(2005). In addition to the selffinancing constraint, the resulting system of hedging equationsforthetraditionKRDmodelis:

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KRD y,ty,k,t c1KRD ,k Dk = Ak ,t c1,k Dk k =1 y=1 n 4 k =1 n

k =1 y=1 n 4

y,t

KRD y,k ,t 2,k

KRD Dk = Ak ,t c2 ,k Dk k =1 n

(17.)

k =1 y=1

y,t

KRD y,k,t c3KRD ,k Dk = Ak ,t c3,k Dk k =1

Also in this case, the error terms have been estimated applying the ordinary least squaretechniquetothechangesinallconsideredzeroratesbetweentimetandt+1, wherethe2year,12year,and22yearzerorateshavebeenusedaskeyratesand havebeenassumedtobealsoexposedtomodelerrors. 3. Thedatasetandthetestingapproach We tested the alternative hedging strategies on 144 monthly periods from December 1996 to December 2008. The portfolio to be hedged is formed by 8 US Treasury bonds and notes. We defined 8 time buckets with maturity equal to respectively 2, 4, 6, 8, 10, 16, 20, and 26 years. In order to select the securities included in the portfolio to be hedged, we impose three conditions: the bonds or notesmusthaveapubliclyheldfacevalueoutstandingofatleast5billionUS$,the firstcouponmustalreadyhavebeenpaidandthematuritydatemustbeascloseas possibletotheoneofthecorrespondingtimebucket 5 . ThehedgingportfoliowasformedbythefourUSTbondandTnotefuture contracts with denomination of respectively 2, 5, 10, and 30 years. We always referredtothenextexpiringfuturecontract.

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For each contract and each month, we identified the cheapesttodeliver bondfollowingthenetbasismethod.AspointedoutbyChoundhry(2006),thereis no consensus about the best way to identify the CTD. The two most common methodsrelyeitheronthenetbasisorontheimpliedreporate(IRR).Inacademia, thesecondmethodisthemostwidelyused,whilepractitionersoftenarguethatthe net basis approach should be used since as pointed out by Chance (1989) it measures the actual profit and loss for a cashandcarry trade. The cheapestto deliver bonds have been identified relying on the monthly baskets of deliverable bondsandconversionfactors(CF)kindlyprovidedtousbytheChicagoMercantile Exchange(CME). We extracted all information related to US Treasury bonds and notes (both forthesecuritiesincludedintheportfoliotobehedgedaswellasforthecheapest todeliverbondsofthefuturecontracts)fromtheCRSPdatabase.Thisincludedboth mid prices and reference data. The closing price of the future contracts has been providedbyDatastream.Frombothdatabases,weonlydownloadedendofmonth data. Inordertoestimatethesensitivityofeachfinancialinstrumenttothethree

selected factors, we calculated the present value of each individual cashflow. For the future contracts, this calculation was based on the cheapesttodeliver bonds. ThediscountrateweusedforthiscalculationreliedontheUnsmoothedFamaBliss zerocouponrates.Themethodologyfollowedfortheestimationoftheserateshas been described in Bliss [1997]. We used the same set of zero rates between May 1975andDecember1991toestimatetheparametersofalltestedhedgingmodels.

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We test our hedging strategies by varying the weights invested in the 8 bonds of the portfolio to be hedged. The first 3 portfolios are identified as bullet portfolios, because the vast majority of the bond positions matures in the same period.Forthe short bullet,thisperiodiswithin5years;forthe medium bullet,itis between8and16years,andforthe long bulletitisover20years.Theotherthree portfolios replicate typical bond portfolio structures: ladders (evenly distributed bondmaturity), barbells(mostbondsmatureeitherintheshorttermorinthelong term),and butterflies(longpositionsinbondsmaturingeitherintheshorttermor inthelongtermandshortpositionsinbondsmaturinginthemediumterm).Theset ofequations (9.)issolvedattheendofeachmonthforeachhedgingstrategyand eachofthe6bondportfolios;thehedgingportfolioforthefollowingmonthisbased ontheresultingweightsyforeachfuturecontract. Inordertoassesthequalityofacertainimmunizationstrategy,weanalyze

theStandardErrorofImmunization(SEI),thatis,theaverageabsolutevalueofthe hedgingerror.Thehedgingerroristhedifferencebetweentheunexpectedreturnof thebondportfoliotobehedgedandtheunexpectedreturnofthefuturesportfolio. Lower SEI indicates higher quality of the immunization strategy. The unexpected return of the bond portfolio is based on the excess return provided by the CRSP databasefortheindividualbonds(thatis,thereturninexcessofwhatwouldhave been computed if the promised yield as of the end of last month had remained constant throughout the hedgingperiod). For the future contracts,the unexpected returnhasbeencalculatedintwodifferentwaysdependingifthecontractexpired duringthehedgingperiodornot.Inthecaseofnoexpiration,theunexpectedreturn

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hasbeensimplycalculatedasthepercentagechangeinthequotedfutureprice.In the case of a contract expiration, the unexpected return has been calculated assuminganopeningofthefuturepositionattheendofthepreviousmonthanda delivery of the cheapesttodeliver bond at the end of the expiration month. The cheapesttodeliverbondhasbeenidentifiedasthebondwiththehighestdelivery volumebasedontheactualdeliverystatisticsprovidedbytheCME. Given the dependency of different hedging strategies on the same case and

time, we estimate statistical significance following an approach of matched pairs experiment.Inotherwords,wecalculatedthedifferencebetweentheabsolutevalue of the hedging errors generated by two strategies on the same case and holding period. Our inference refers to the mean value of this difference. As a benchmark model,weusetheerroradjustedPCA,whichwasexpectedtobethebestperformer. For each hedging problem, we also estimate the square root of the average sumofthesquaredweightsyexpressedaspercentagesofthebondportfoliovalue. This estimate is a useful proxy of the level of transaction costs implied by each hedging strategy. In fact, these costs are normally proportional to the sum of the absolute value of all long and short future positions. This statistic can also give a broadideaoftheexposuretomodelerrorsimpliedbyacertainstrategy. Finally, we analyzed our dataset in order to assess when market yields should be considered too close to the notional coupon of the future contracts. As explained in section 2.1, we intend to base our subsample analysis on this assessment.Thiswillallowustoisolatetheobservationsforwhichtheimpactofthe deliveryoptionislikelytobetangiblefromtherestofthesample.

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WefollowedGrievesetal.(2010)indefiningtoocloseasanabsolutedistance not greater than 0.5%. The next figure highlights the period during which market yieldswerewithinthisdistancefromthenotionalcoupon.Itwastheperiodstarting from March 2000 (when the notional coupon was lowered from 8% to 6%) and endinginJune2004(whenthemarketyieldofthe30yearbondbrieflytouchedthe lowerlimitofourrange).Accordingly,wewillusethesetwodatestolimitoursub samples. Figure1 Assessingthedistancebetweentheyieldsofthe2year,5year,10yearand30year Treasurybondsandthefuturenotionalcoupon(Source:Datastream)
8

USBD30Y USBD10Y USBDS 5Y

USBDS 2Y

0 02.12.1996 02.06.1997 02.12.1997 02.06.1998 02.12.1998 02.06.1999 02.12.1999 02.06.2000 02.12.2000 02.06.2001 02.12.2001 02.06.2002 02.12.2002 02.06.2003 02.12.2003 02.06.2004 02.12.2004 02.06.2005 02.12.2005 02.06.2006 02.12.2006 02.06.2007 02.12.2007 02.06.2008 02.12.2008

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4. Theresults After estimating the parameters of the tested models between May 1975 and December1991,weanalyzed the size of the model errors onthesame sample. As expected, all models explain a high proportion of the variance of interest rate changes,butthisproportionisslightlyhigherforthePCAmodel (circa 95%)than fortheDVmodel(circa93%)andtheKRDmodel(circa92%).Themainreasonfor theworstperformanceofthelattermodelsistheirinabilitytocorrectlyaccountfor the term structure of volatility (i.e.: the higher volatility of shortterm rates). The GDVmodelsharesthisstrengthofthePCAmodelandleadstosimilarmodelerrors. The results of the strategies based on the PCA, DV, and KRD models are

reportedinExhibits1to3.Forthesakeofbrevity,wehavenotreportedtheresults provided by the GDV model which led to significantly worse hedging than the simplerDVmodel.Thisoutcomeisnotconsistentwiththeabovementionedfindings of Nawalkha et al. [2003]. We believe that the reason for this inconsistency is the relativelyhighsensitivityofthefuturestochangesinthezerorateofmaturitys(the expirationdateofthecontract),whichaffectsthefullcostofcarry 6 .Thisleadstoa highexposuretomodelerrorswhichoverwhelmstherelativelygoodqualityofthe underlyingprocessofinterestratechanges. Exhibit 1 shows a comparison of the results of the three methods in their traditional forms. As expected, the relative performance largely depends on the exposure to model errors: the model leading to lower squared weights statistics generally leads to lower SEI. Since these statistics can randomly vary from one hedgingproblemtotheother,alsotherelativeperformancepresentsahighdegree

21

ofrandomness.Onaverage,thehedgingqualityofthethreemodelsiscomparable: thePCAmodelhappenstobethemodelleadingtothelowestaverageexposureto model errors and also to the lowest average SEI. The overall quality of the three models is not outstanding: on average, the hedging error represents circa 20% of theunexpectedreturnvolatilityweintendedtohedge. Exhibit1 Testingthemostcommonhedgingtechniquesintheirtraditionalform.(December 1996December2008,144monthlyobservations)
Portfoliotobe CaseDescription hedged Standarddeviationof unexpectedreturn ShortBullet MediumBullet LongBullet Ladder Barbell Butterfly Average 1.44% 1.84% 2.18% 1.82% 1.81% 1.81% 1.81% SEI
(1) (2)

TraditionalPCA Squared weights 1.99 2.22 3.23 2.60 3.02 3.64 2.78
(3)

TraditionalKRD Squared SEI

(2)

TraditionalDV Squared SEI

(2)

weights 1.18 1.48 4.61 2.92 4.41 6.57 3.53

weights 1.38 1.68 4.85 3.16 4.58 6.62 3.71

0.27% *** 0.31% *** 0.41% *** 0.33% *** 0.36% *** 0.41% *** 0.35%

0.20% *** 0.24% *** 0.46% *** 0.33% *** 0.43% *** 0.57% *** 0.37%

0.22% *** 0.26% *** 0.49% *** 0.35% *** 0.45% *** 0.60% *** 0.39%

Note:(1)SEI(StandardErrorofImmunization)representstheaverageabsolutevalueof thehedgingerror;thehedgingerroristhedifferencebetweentheunexpectedreturnof the bond portfolio to be hedged and the unexpected return of the future portfolio. (2) Statisticalsignificanceisrelatedtotheaveragedifferencebetweentheabsolutevalueof thehedgingerrorsforthetestedstrategyandtheerroradjustedPCA:*indicates10% significance, ** indicates 5% significance, and *** indicates 1% significance. (3) It indicates the square root of the average sum of the squared weights y expressed as percentagesofthevalueofthebondportfolio.

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Oursecondstepistoanalyzetheperformanceofthethreemethodsintheir correspondingerroradjustedversions.InExhibit2,wecomparetheseresults.They support our initial hypothesis that controlling the exposure to the model errors significantlyimprovesthehedgingquality.Inparticular,theerroradjustmentleads toanaveragereductionintheSEIforthePCAmodelof46%(from0.35%to0.19%), whereas this reduction equals 38% for the KRD and 49% for the DV models. This reduction is statistically significant for each model and each of the 6 tested bond portfolios. The reduction in the squared weights statistics obtained for the error adjusted models is also very substantial, thus highlighting a second important advantageofthisadjustment:thecutintransactioncosts.Ifthecostsofsettingup thehedgingstrategyareindeedproportionaltooursquaredweightsstatistics,then the reduction in these costs would be around 80% for each of the three reported models. A very relevant observation we can make on Exhibit 2 is that once we control the exposure to the model errors the superior quality of the process of interest rate changes underlying the PCA model seems to emerge consistently: on each of the 6 tested bond portfolios, the PCA model outperforms both alternative models and in several cases this outperformance is statistically significant. This stronglydiffersfromtherandomnessintherelativeperformanceofthetraditional modelsdisplayedbyExhibit1.Theoverallqualityofthethreemodelsisnowquite good, especially if one considers that the hedging is based on different financial instruments(i.e.:futures)thantheonesincludedintheportfoliotobehedged(i.e.: bonds) and their corresponding prices come from two different markets and data

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providers: the hedging error normally ranges between 10% and 12% of the unexpectedreturnvolatilityweintendedtohedge. Exhibit2 Testing the most common hedging techniques in their erroradjusted form. (December1996December2008,144monthlyobservations)
ErrorAdjustedPCA CaseDescription SEI ShortBullet MediumBullet LongBullet Ladder Barbell Butterfly Average
(1) (2)

ErrorAdjustedKRD Squared SEI 0.16% 0.19%

(2)

ErrorAdjustedDV Squared SEI 0.17% 0.20% 0.22% 0.19% 0.20%

(2)

Squared weights 0.51 0.60 0.72 0.58 0.62 0.76 0.63

(3)

weights 0.54 0.62 0.91 0.67 0.78 0.98 0.75

weights 0.54 0.59 0.73 0.59 0.60 0.62 0.61

0.16% 0.19% 0.22% 0.19% 0.19% 0.20% 0.19%

** * *

0.27% *** 0.21% *** 0.25% *** 0.31% *** 0.23%

0.24% *** 0.20%

Note:(1)SEI(StandardErrorofImmunization)representstheaverageabsolutevalueofthe hedging error. The hedging error is the difference between the unexpected return of the bondportfoliotobehedgedandtheunexpectedreturnofthefutureportfolio.(2)Statistical significanceisrelatedtotheaveragedifferencebetweentheabsolutevalueofthehedging errors for the tested strategy and the erroradjusted PCA: * indicates 10% significance, ** indicates 5% significance, and *** indicates 1% significance. (3) It indicates the squarerootoftheaveragesumofthesquaredweights yexpressedaspercentagesofthe valueofthebondportfolio.

Finally, we report in Exhibit 3 the hedging quality statistics we would have obtainediftheperformanceofthehedgingportfoliowouldhavebeencalculatedon theinitialcheapesttodeliverbonds,insteadofonthefuturecontracts.Thepurpose ofthisexhibitistoprovideuswithanattributionofthehedgingerror.Infact,the differencebetweentheSEIreportedinExhibit1(Exhibit2)andtheonereportedin Exhibit 3 for the traditional (erroradjusted) form of the tested models is an

24

estimateoftheimpactonthehedgingerrorsofelementswhicharespecifictothe futurecontractsandarenotreflectedbytheinitialcheapesttodeliverbond.

Exhibit3 Calculating the performance of hedging models based on the initial cheapestto deliverbonds(December1996December2008,144monthlyobservations).
CaseDescription ShortBullet MediumBullet LongBullet Ladder Barbell Butterfly Average Traditional 0.22% 0.25% 0.35% 0.29% 0.32% 0.37% 0.30%
(1)

PCA ErrorAdjusted 0.06% 0.08% 0.11% 0.08% 0.09% 0.12% 0.09%

(1) (1)

KRD Traditional ErrorAdjusted 0.11% 0.13% 0.36% 0.24% 0.35% 0.50% 0.28% 0.08% 0.10% 0.17% 0.12% 0.16% 0.23% 0.14%
(1) (1)

DV Traditional ErrorAdjusted 0.14% 0.16% 0.41% 0.28% 0.39% 0.55% 0.32% 0.08% 0.10% 0.11% 0.08% 0.10% 0.16% 0.10%
(1)

Note:(1)SEI(Standard ErrorofImmunization) representstheaverageabsolutevalue ofthehedgingerror.Thehedgingerroristhedifferencebetweentheunexpectedreturn ofthebondportfoliotobehedgedandtheunexpectedreturnofthefutureportfolio.The latter unexpected return has been calculated based on the cheapesttodeliver bonds identifiedatthebeginningofthehedgingmonthandnotlikeinthepreviousexhibits onthequotedfutureprices.

Exhibit 3 highlights that these futurespecific elements explain a relevant portionofthehedgingerrorsfortheerroradjustedmodels.Forexample,Exhibit3 shows that using the initial cheapesttodeliver bonds as hedging vehicles would haveledthePCAmodeltoanaveragehedgingerrorof0.09%.InExhibit2,wehave seen that usingthe futures would have led the same model to an average hedging errorof0.19%.Accordingly,morethan50%ofthelattererrorseemstobedueto futurespecificelements.

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Sincetheyaccountforsuchahighproportionofthehedgingerrors,itmakes sense to analyze these futurespecific elements more in detail. We start from the elementweexpecttoplaytheleastimportantrole:atemporarymispricingbetween thespotandfuturebondmarkets.Beingbondfuturesandtheircheapesttodeliver bondsveryliquid,weexpectspeculatorstoquiterapidlytakeadvantagefromthis kindofopportunities.Accordingly,wedonotexpectasizeablemispricingtostayin themarketfortoolongandtosignificantlyinfluencemonthlyreturns. Asecondelementofthiskindisrepresentedbythedifferenceinthetimeat whichspotandfuturepricesareobserved(5pmforbonds,2pmforfutures)andin theirmeaning(midpriceforbonds,closingpriceforfutures).Alsointhiscase,we wouldnormallynotexpectasizeableimpactofsuchdifferencesonmonthlyreturns. Moreover,thesedifferencesarespecifictoourtestingdataset,butwouldnotaffecta reallife hedging problem. Accordingly, they probably make our hedging strategies basedonbondfutureslookingslightlyworsethantheyreallyare. The elements we expect to explain the vast majority of the futurespecific hedging errors are actual changes in the cheapesttodeliver bonds and/or in the value of the embedded options. The subsample analysis is likely to give us an indication of the potential size of these effects, since we know that they are much morerelevantinthesecondsubsample(goingfromMarch2000toMay2004)than in the first subsample (going from December 1996 to February 2000) or in the thirdone(goingfromJune2004toDecember2008).Thenextexhibitsummarizes theresultsofoursubsampleanalysis.

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Exhibit4 Alternativehedgingmodelsbasedonbondfutures:subsampleanalysis.
CaseDescription SubSample1 ShortBullet MediumBullet LongBullet Ladder Barbell Butterfly Average SubSample2 ShortBullet MediumBullet LongBullet Ladder Barbell Butterfly Average SubSample3 ShortBullet MediumBullet LongBullet Ladder Barbell Butterfly Average PCA Traditional Dec.1996toFeb.2000 15.10% 14.68% 21.40% 18.55% 22.76% 27.67% 20.03% March2000toMay2004 20.28% 18.36% 16.70% 17.96% 18.23% 18.61% 18.36% June2004toDec.2008 18.67% 17.27% 19.07% 18.81% 20.69% 23.90% 19.74%
(1)

KRD Error (1) Adjusted 9.27% 8.70% 10.15% 9.69% 10.73% 12.38% 10.15% 13.31% 12.57% 11.79% 12.35% 12.27% 12.12% 12.40% 9.58% 9.07% 8.19% 8.63% 8.59% 9.13% 8.87% Traditional 14.29% 14.15% 31.97% 24.75% 35.11% 48.63% 28.15% 14.89% 14.16% 12.33% 12.97% 13.02% 13.55% 13.49% 13.10% 11.90% 23.56% 19.43% 27.56% 39.06% 22.44%
(1)

DV Error (1) Adjusted 10.17% 9.76% 13.10% 11.71% 13.83% 17.71% 12.71% 12.35% 11.59% 11.63% 11.61% 12.48% 13.77% 12.24% 11.04% 9.68% 12.83% 11.93% 14.65% 19.45% 13.26% Traditional 16.62% 16.43% 36.75% 28.79% 40.43% 55.91% 32.49% 15.12% 14.08% 13.71% 13.86% 14.80% 15.95% 14.59% 13.98% 12.46% 22.19% 18.88% 25.55% 35.20% 21.38%
(1)

Error (1) Adjusted 10.36% 9.60% 9.36% 9.45% 10.09% 12.63% 10.25% 12.89% 12.21% 12.49% 12.38% 13.22% 15.32% 13.09% 11.39% 10.32% 8.55% 9.07% 9.18% 10.86% 9.89%

Note: (1) SEI (Standard Error of Immunization) as a percentage of the standard deviationoftheunexpectedreturnfromthebondportfoliotobehedged.SEIrepresents the average absolute value of the hedging error. The hedging error is the difference betweentheunexpectedreturnofthebondportfoliotobehedgedandtheunexpected returnofthefutureportfolio.

Our subsample analysis highlights the robustness of the erroradjustment. Only in one case (the KRD hedging of the butterfly portfolio in the second sub

27

sample) the traditional model performs better than the erroradjusted one. Accordingly, the erroradjustment still works when the impact of the options to deliveronthehedgingportfolioistangible,likeinthesecondsubsample. AlsothesuperiorityoftheerroradjustedPCAmodeloverthecorresponding DV and KRD models is largely confirmed by the subsample analysis. On average (eventhoughnotinanytestcase),thePCAoutperformstheDVineverysubsample andtheKRDintwoofthethreesubsamples. Let us now come to our initial question on the impact of changes in the cheapesttodeliver bonds and/or in the value of the embedded options on the hedging quality. Exhibit 4 does indeed highlight a worsening of this quality in the second subsample for the two best models (the erroradjusted PCA and DV). The sizeofthisworseningisaround3%ofthevolatilityweintendedtohedge.Forthe erroradjustedKRDmodel,thesecondsubsamplehappenstobetheonedisplaying the best hedging performance, even though the results of this model are pretty similaroverallthreesubsamples. Basedonthelatestobservations,wecansaythatvaluableoptionstodeliver have a limited impact on our erroradjusted models, at least in percentage terms. Nevertheless, we should ask ourselves where the worsening displayed by the PCA andDVmodelsinthesecondsubsamplemightbecomingfrom.Doesitcomefrom oursimplifiedestimationofthefuturessensitivityignoringtheoptionstodeliver? Ordoesitrathercomefromthefactthat"the future price not only does not behave like any one bond or note, but behaves instead like a complex hybrid of the bonds and notes in the deliverable set.." (Burghardt et al. (2005)), a statement which is

28

particularly true when market yields are close to the notional coupon? In other words,istheslightworseninginthesecondsubsampledueto a weaknessinour modeling or to a weakness of futures as hedging instruments? We suspect the second element to be the most relevant one: changes in the cheapesttodeliver bonds during the hedging month are almost 5 times more frequent in the second subsample than in the remaining subsamples, thus making the sensitivity of the contractsintrinsicallyunstable.Aformalanddocumentedanswertothisquestionis lefttofurtherresearchefforts. 5. Conclusions Our results highlight that traditional implementations of the models most commonlyusedforhedgingyieldcurverisktendtoleadtohighexposuretomodel errors and to sizable transaction costs, thus lowering the hedging quality and makingaclearrankingofthemodelsdifficult.Infact,theexposuretomodelerrors generatedbyacertainmodelvariesquiterandomlyacrosshedgingproblems. As a consequence, including some mechanisms to control the exposure to model errors is of paramount importance for a sound implementation of these models. We presented the results of explicitly accounting for the variance of the modelerrorsdisplayedbyeachzerorate.Wefoundoutthatthereductioninboth the hedging errors and the transaction costs is very substantial: the errors are reducedonaverageby46%forthePCAmodel,by38%fortheKRDmodelandby 49% for the DV model. If the costs of settingup the strategies areproportional to

29

oursquaredweightsstatistics,thereductioninthesecostswouldbecirca80%for allthreemodels. A further benefit of the error adjustment is to make the model ranking consistent and often statistically significant: the erroradjusted PCA model outperforms both alternative models on every single hedging case. To the best of ourknowledge,thisresultisnew.Weattributeittothebetterqualityoftheinterest rateprocessunderlyingthePCAmodel,whichexplainsthelargestpossiblepartof thevarianceofyieldcurveshiftsbasedonthreeorthogonalfactors. Finally, our study shows that bond futures can effectively be used to hedge the yield curve risk of a bond portfolio. When erroradjusted models are applied, only10%12%oftherisktobehedgedisleftasahedgingerror(grossoftheeffect of the 3hour difference between spot and future endofday prices). This is still more than what we would obtain by using bonds to hedge other bonds. However, futures present other advantages, such as strongly reduced need of cash, higher liquidity,andlowertransactioncosts. All abovementioned results have been found to be robust to subsample analysis.Particularly,sinceweappliedasimplifiedestimationoffuturessensitivity ignoring the options to deliver, we checked this robustness on the second sub period from March 2000 to May 2004, during which these options have been particularlyvaluable.Eventhoughwedidnoticeaworseninginthehedgingquality ofPCAandDVmodelsforthissubsample,thisamountedtoonly3%ofthevolatility weintendedtohedge.

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An important challenge we leave open to further research concerns the developmentofhedgingtechniquesreconcilinganadjustmentformodelerrorswith termstructuremodelscapableofproperlyassessingthesensitivityoftheembedded optionstoyieldcurvechanges.Afurtherimprovementofthepresentpapercouldbe represented by the explicit consideration of futurespecific model errors in the applicationoftheerroradjustment.Bothdevelopmentsshouldatleastintheory lead to further improvements in the hedging quality relatively to the results reportedinthispaper.

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REFERENCES Bierwag,G.O.,G.G.KaufmanandC.M.Latta,1987.Bondportfolioimmunization:Test ofmaturity,oneandtwofactordurationmatchingstrategies.TheFinancialReview, May. Bierwag, G.O., (1987). Duration analysis: Managing interest rate risk. Ballinger, Cambridge,MA. Bliss, Robert R., 1997. Testing term structure estimation methods. Advances in FuturesandOptionsResearch,9.pp.197231. Burghardt,G.D.,Belton,T.M.,LaneM.,and,J.Papa,2005.TheTreasuryBondBasis. Libraryofinvestmentandfinance.McGrawHill,thirdedition. Carcano, N., 2009. Yield curve risk management: adjusting principal component analysisformodelerrors.TheJournalofRisk,12,n.1. Carcano, N.. and S. Foresi, 1997. Hedging against interest rate risk: reconsidering volatilityadjustment immunization. Journal of Banking and Finance, 21, pp. 127 143. Chambers, D. R., W. T. Carleton, and R. M. McEnally, (1988). Immunizing Default Free Bond Portfolioswith a Duration Vector, Journal of Financial and Quantitative Analysispp.89104. Chance,DonM,(1989)AnintroductiontoDerivatives.4thed.Dryden,Virginia,. Choudhry, M., 2006. The Futures Bond Basis, John Wiley and Sons, LTD. West Sussex,England.

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CollinDufresne,P.,R.Goldstein,andM.Spencer,2001,TheDeterminantsofCredit SpreadChanges,TheJournalofFinance,Vol.56,No.6,pp.21772205 Elton, Edwin J., Martin J. Gruber, Deepak Agrawal, and Christopher Mann, 2001, Explainingtheratespreadoncorporatebonds,JournalofFinance56,247277. Fisher, L. and R.L. Weil, 1971. Coping with the risk of interest rate fluctuations: Returnstobondholdersfromnaiveandoptimalstrategies.JournalofBusiness,Oct. Fleming,J.andWhaley,R.E.,1994.Thevalueofwildcardoptions.JournalofFinance 49,pp.215236 Fong,H.G.,andF.J.Fabozzi,1985.Derivationofriskimmunizationmeasures.Fixed IncomePortfolioManagement.DowJonesIrwin,Homewood,IL,pp.291294. Grieves,R.,&Marcus,A.(2005).DeliveryoptionsandTreasurybondfutureshedge ratios.JournalofDerivatives,13,7076. Grieves,R.,Marcus,A.andWoodhamsA.,(2010).Deliveryoptionsandconvexityin Treasurybondandnotefutures.ReviewofFinancialEconomics,19pp17. Henrard, M., (2006), Bond Futures and Their Options: More than the Cheapestto Deliver;QualityOptionandMargining,JournalofFixedIncome,September,Vol.16, No.2,pp.6275. Ho,T.S.Y.Keyratedurations:Measuresofinterestraterisks,(1992)JournalofFixed Income,September,pp2944. Hodges, S., and N. Parekh. (2006), Termstructure slope risk: convexity revisited. JournalofFixedIncome,Winter,Vol.16,Iss.3,pp.5460.

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Klotz, Richard G., (1985) Convexity of fixedincome securities. Salomon Brothers, NewYork. Litterman, R., and J. Scheinkman, (1988) Common factors affecting bond returns. FinancialStrategiesGroupPublications,SeptemberGoldman,Sachs&Co,NewYork. Macaulay, Frederick R., (1938) The movements of interest rates, bond yields and stockpricesintheUnitedStatessince1856.NationalBureauofEconomicResearch, NewYork. Martellini, L., and P. Priaulet, 2001. Fixedincome securities: dynamic methods for interest rate risk pricing and hedging. John Wiley & Sons Ltd, Baffins Lane, Chichester,England. Nawalkha, S.K., G.M. Soto, and N. A. Beliaeva, (2005) Interest Rate Risk Modeling. JohnWiley&Sons,Inc.Hoboken,NewJersey. Nawalkha, S.K., G.M. Soto, and J. Zhang, (2003) Generalized MVector Models for HedgingInterestRateRisk.JournalofBanking&Finance.27pp15811604 Nawalka,S.K:,andD.R.Chambers,1997.TheMVectormodel:Derivationandtesting ofextensionstoMsquare.JournalofPortfolioManagement.Winter,pp.9298. Kuberek,RobertC.andNormanG.Pefley,(1983).HedgingCorporateDebtwithU.S. TreasuryBondFutures,TheJournalofFuturesMarkets,(Winter),Vol.3No.4,pp. 345353. Rendleman, R. J., (2004), Delivery Options in the Pricing and Hedging of Treasury BondandNoteFutures.JournalofFixedIncome,September,pp.2031.

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ENDNOTES Theoriginalformulationofdurationreliedonflatyieldcurves,butthisrestriction wasovercomethankstotheformulationproposedbyFisherandWeil(1971).For anextensivereviewofhowtheconceptofdurationwasdevelopedduringthelast century,seeBierwag(1987).

1

2Nawalkhaetall.[2005]affirmthattheDVmodelmustbeconsideredmorerobust

andsuitableforhedgingpurposeswhentimeseriesofinterestratechangesare nonstationary,sinceinthiscasetheestimatesofPCAmodelsarehighlyinstable. TheyalsohighlightthattheKRDmodelleadstoanarbitraryselectionofthenumber andmaturityofthekeyratesandtoimplausibleshapesfortheyieldcurveshifts.

3Thefirsttimeoptionconsistsinthepossibilityfortheshortpositiontodeliverat

anytimeduringtheexpirationmonth(generallyspeaking,earlydeliveryis preferableifthecostoffinancingexceedstheCTDcouponandviceversa).The secondtimeoptionthesocalledendofthemonthoptionconsistsinthe possibilityfortheshortpositiontodeliverduringthefinalbusinessdaysofthe deliverablemonthaftertheinvoicepricehasbeenlockedin.Thethirdtimeoptionis thesocalledwildcardoption.Itconsistsinthepossibilityfortheshortpositionto lockintheinvoicepriceat3pmduringthedeliverymonthandmakethedeliveryif thespotpricefallsbelowtheestablishedinvoicepricebetween3pmand5pm. For the PCA model, this assumption is fulfilled by construction. Considering the wayhowweestimatedtheerrorterms(t,DK)fortheothermodels,thisassumption isalsofulfilledbyconstructionasfarastheindependencybetweentheerrorterm andthefittedvalueofthesamezerorateisconcerned.FormodelsotherthanPCA, theindependencybetweentheerrorterm (t, DK)andthefittedvalueofzerorates withmaturityotherthanDKisasimplifyingassumption.
4 5

Thefirstconditionensuresagoodlevelofliquidityfortheconsideredsecurities, whilethesecondoneallowsustoavoidthecomplexitylinkedtothepotential irregularityofthefirstcouponpaymentandthethirdoneleadstospreadthe securitiesasevenlyaspossiblewithintheselectedrangeofmaturities.

Givenourtestingapproach,thematuritysisveryshort(rangingfromonetothree months).Now,theGDVmethodleadstomuchhighervaluesofthesensitivity parametersclforveryshorttermratesthanforanyotherrate.Sincetheportfolioto behedgeddisplaysamuchlowersensitivitytochangesinveryshorttermrates thanthefuturecontracts,theGDVminimizationprocedureleadstowidelongshort futurepositionshavingthegoalofoffsettingthehighsensitivityofthezerorateof maturitystothethreeriskfactors.

6

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c/o University of Geneva 40 bd du Pont d'Arve 1211 Geneva 4 Switzerland T +41 22 379 84 71 F +41 22 379 82 77 RPS@sfi.ch www.SwissFinanceInstitute.ch