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FRM Part I · FRM Exam Part I · Modeling Non-Parallel Term Structure Shifts and Hedging

A risk manager models yield curve changes with two factors, a level shift and a slope change. She wants a portfolio of bonds hedged against both. Which statement about the hedge is correct?

Hedging two yield curve factors requires at least two instruments with different sensitivities to level and slope. One DV01-matched futures contract covers only a parallel shift and leaves slope risk. The two exposure equations can be solved only with two instruments.

  1. AA single futures contract is enough if its DV01 equals the portfolio DV01.
  2. BAt least two hedging instruments with different exposure profiles to the two factors are needed.Correct
  3. CHedging the level factor automatically neutralises the slope factor because the factors are correlated.
  4. DThe slope factor can only be hedged by using options rather than futures or swaps.

Explanation

To neutralise two factor exposures you must solve two equations, so you need at least two instruments whose sensitivities to the factors differ. A single DV01-matched contract hedges only a parallel shift and can leave slope exposure. The factors are constructed to be uncorrelated, so hedging one does not hedge the other.

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