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

A risk manager notes that a regression hedge of a swap book using the 10-year swap rate has a low R-squared over the past year, while a PCA-based hedge using the first three principal components performs better. Which statement best explains why a simple DV01 hedge against parallel shifts may leave residual risk?

A DV01 hedge assumes a parallel shift in yields, so it neutralizes only level risk. Real curve movements also involve slope and curvature, the second and third principal components, which can leave residual risk in the hedged position.

  1. ADV01 hedging assumes all rates move by the same amount, but curve changes also include slope and curvature movesCorrect
  2. BDV01 hedging ignores the level of interest rates entirely, so it cannot hedge any rate move
  3. CDV01 hedging works only for zero-coupon instruments and fails for coupon bonds
  4. DDV01 hedging eliminates level risk but increases exposure to parallel shifts

Explanation

A DV01 hedge is neutral to a parallel shift, which corresponds roughly to the first principal component (level). Slope and curvature components can still change the hedged value. The other options misstate what DV01 captures.

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