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

A risk manager estimates a hedge ratio by regressing changes in the yield of the hedged bond on changes in the yield of the hedging instrument. After a regime change, the manager notices that the relationship estimated over the last ten years differs from that of the last six months. Which is the most appropriate implication for hedging?

The manager should consider re-estimating the hedge ratio using recent or weighted data. A regression hedge depends on a stable relationship between the two yields, so after a regime change a long, old sample may give a misleading hedge ratio.

  1. AIgnore the recent data because longer samples are always more accurate
  2. BConsider re-estimating with more recent or weighted data, since the hedge ratio is only as good as the stability of the relationshipCorrect
  3. CSet the hedge ratio to one because regressions are unreliable
  4. DIncrease R-squared by adding more years of data

Explanation

Regression hedges rely on a stable historical relationship; after a structural change, recent or exponentially weighted data better reflects current sensitivities. Longer samples are not always better, and a ratio of one ignores the estimated relationship. Adding older data does not improve current fit.

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