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A Futures Duration‐Convexity Hedging Method
Author(s) -
Daigler Robert T.,
Copper Mark
Publication year - 1998
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/j.1540-6288.1998.tb01397.x
Subject(s) - convexity , hedge , duration (music) , futures contract , econometrics , imperfect , term (time) , economics , nonlinear system , mathematics , financial economics , physics , ecology , linguistics , philosophy , quantum mechanics , acoustics , biology
A duration‐based hedge ratio is the conventional method to hedge against price changes of a fixed‐income instrument. However, the relationship between bond prices and interest rates is nonlinear, creating a convexity effect. Moreover, term structure changes often are nonparallel in nature, which causes imperfect hedges for the duration‐based hedging model. One solution to these problems is to dynamically change the duration‐based hedge ratio; however, this procedure is costly and is not effective when jumps in prices occur. A superior solution is to develop a two‐instrument hedge ratio that simultaneously hedges both duration and convexity effects. This paper first presents such a two‐instrument hedge ratio and then we examine its effectiveness. The simulation results show that this duration‐convexity hedge ratio is vastly superior to alternative hedge ratio methods for both simple and complex changes in the term structure.