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

A trader hedges a bond position's exposure to the first two principal components using two hedging instruments. Compared with a single-instrument DV01 hedge, what is the main advantage of the two-factor PCA hedge?

A two-factor PCA hedge neutralizes exposure to both level and slope, which together usually explain the bulk of curve variance. It does not remove risk from higher components or eliminate rebalancing, but it leaves much less residual risk than a DV01-only hedge.

  1. AIt removes exposure to the third and higher components entirely
  2. BIt guarantees a zero hedging error under all curve movements
  3. CIt controls exposure to both level and slope moves, which together explain most curve varianceCorrect
  4. DIt eliminates the need to rebalance as the curve moves

Explanation

Matching exposure to the first two components covers level and slope, usually most of the variance. Residual risk from higher components remains, and the hedge still needs rebalancing as factor loadings and exposures change.

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