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

A risk manager regresses daily changes in the yield of a 10-year bond position (dependent variable) on daily changes in the yield of a 10-year futures-implied reference rate (independent variable) to design a hedge. In a regression-based hedge of this kind, what does the estimated slope coefficient (beta) represent?

The slope coefficient is the expected change in the position's yield for a one-unit change in the hedging instrument's yield. It scales the hedge. R-squared measures variance explained, the residual standard error measures hedge error, and the intercept is the level at zero change.

  1. AThe expected change in the position's yield per unit change in the hedging instrument's yieldCorrect
  2. BThe proportion of variance in the position's yield changes explained by the hedging instrument
  3. CThe standard deviation of the hedging errors
  4. DThe expected yield level of the position when the hedging instrument's yield is zero

Explanation

The slope measures the expected change in the dependent variable per unit change in the independent variable, and it is used to scale the hedge. The proportion of variance explained is R-squared, the hedging error spread is the residual standard error, and the intercept gives the level when the regressor is zero.

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