Structure of spot rates and duration hedging
Journal
Asia-Pacific Journal of Financial Studies
Journal Volume
40
Journal Issue
4
Pages
550-576
Date Issued
2011
Author(s)
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.
Type
journal article