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Structure of Spot Rates and Duration Hedging *

Structure of Spot Rates and Duration Hedging * The present study proposes a three‐factor model using spot rates as proxies for the state variables of the term structure of interest rates. Empirical analysis is carried out on the in‐sample explanatory power and the out‐of‐sample prediction ability of spot‐rate models, and comparison is made between the modified Macaulay duration and spot‐rate duration hedging for bond portfolios. The results not only show that the optimal three‐spot‐rate model outperforms the optimal two‐spot‐rate model proposed by Elton et al. (Journal of Finance, 45, 1990, 629–642) with respect to explanation ability of unexpected changes in the term structure of interest rates, but also illustrate the importance of capturing the curvature characteristic of the term structure of interest rates for spot‐rate duration hedging methods. Moreover, the impressive performance of three‐spot‐rate duration hedging implies that it is feasible to reduce the dimensions of state variables to three for the purposes of risk exposure prediction and risk management of bond portfolios. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Asia-Pacific Journal of Financial Studies Wiley

Structure of Spot Rates and Duration Hedging *

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Publisher
Wiley
Copyright
© 2011 Korean Securities Association
ISSN
2041-9945
eISSN
2041-6156
DOI
10.1111/j.2041-6156.2011.01049.x
Publisher site
See Article on Publisher Site

Abstract

The present study proposes a three‐factor model using spot rates as proxies for the state variables of the term structure of interest rates. Empirical analysis is carried out on the in‐sample explanatory power and the out‐of‐sample prediction ability of spot‐rate models, and comparison is made between the modified Macaulay duration and spot‐rate duration hedging for bond portfolios. The results not only show that the optimal three‐spot‐rate model outperforms the optimal two‐spot‐rate model proposed by Elton et al. (Journal of Finance, 45, 1990, 629–642) with respect to explanation ability of unexpected changes in the term structure of interest rates, but also illustrate the importance of capturing the curvature characteristic of the term structure of interest rates for spot‐rate duration hedging methods. Moreover, the impressive performance of three‐spot‐rate duration hedging implies that it is feasible to reduce the dimensions of state variables to three for the purposes of risk exposure prediction and risk management of bond portfolios.

Journal

Asia-Pacific Journal of Financial Studies – Wiley

Published: Aug 1, 2011

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