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

A trader holds a long position in a bond with a DV01 of USD 4,500 per basis point. She wants to hedge against a parallel shift in yields using a hedging bond with a DV01 of USD 750 per USD 1 million face value (per bp). How should the hedge be implemented?

She should sell USD 6 million face of the hedging bond. The hedge ratio is 4,500 divided by 750 per million, giving 6 million, and a short position is required because the long bond loses value when yields rise, so the hedge must gain.

  1. ABuy USD 6 million face value of the hedging bond
  2. BSell USD 6 million face value of the hedging bondCorrect
  3. CSell USD 600 million face value of the hedging bond
  4. DSell USD 0.6 million face value of the hedging bond

Explanation

Hedge face amount = 4,500 / 750 = 6 units of USD 1 million, i.e. USD 6 million face. Because the trader is long the bond, she loses when yields rise, so she must sell the hedging bond. Buying would double the exposure rather than offset it.

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