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FRM Part II · FRM Exam Part II · Regression Hedging and Principal Component Analysis

A bank's liability book has a DV01 of USD 50,000 and a dollar-duration hedge using a swap is put in place. Over the next month, the actual yield changes of the hedged position and hedge instrument are not perfectly parallel. Which is the main limitation of this single-factor DV01 hedge?

A single DV01 hedge protects only against the assumed single-factor move, usually a parallel shift. Slope and curvature changes in the yield curve still leave residual risk, which is the motivation for multi-factor approaches such as principal component analysis hedging.

  1. AIt cannot be computed for coupon-paying bonds
  2. BIt hedges only the exposure to the assumed parallel or single-factor shift, leaving slope and curvature riskCorrect
  3. CIt always overhedges because DV01 ignores the bond price
  4. DIt eliminates yield risk only if beta is below one

Explanation

A DV01 hedge neutralizes sensitivity to one assumed yield move, typically a parallel shift. Non-parallel moves such as steepening or curvature changes leave residual risk, which is why PCA-based multi-factor hedges are used.

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