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

A risk manager uses a two-variable regression hedge, regressing changes in a bond's yield on changes in the 2-year and 10-year swap rates, instead of a single-instrument hedge. Which statement best describes the main benefit and a key caveat of this approach?

A multi-instrument regression hedge can address non-parallel yield moves such as level and slope changes, improving the fit versus a single hedge. The caveat is that coefficients are estimated from historical data, so they may be unstable and residual risk remains. It does not eliminate all risk.

  1. AIt can hedge exposure to both level and slope-type moves, but the estimated hedge relies on historical relationships that may be unstableCorrect
  2. BIt removes all risk because the regression residual is zero by construction
  3. CIt guarantees hedge ratios equal to the DV01 ratio, so no estimation is needed
  4. DIt makes hedge ratios independent of the sample period used

Explanation

Adding a second regressor lets the hedge capture non-parallel moves such as slope changes, improving fit. However, the coefficients are estimated from past data and can change, so hedge performance is not guaranteed. Residual risk remains, hedge ratios are not equal to DV01 ratios, and they do depend on the sample.

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