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

Which statement best describes a key limitation of a single-factor regression hedge compared with a principal component analysis based hedge of a bond portfolio exposed to the whole yield curve?

A single-variable regression hedge covers only one source of yield movement, so exposure to other curve shape changes such as twists and curvature remains. PCA hedges across several independent factors like level, slope and curvature.

  1. ARegression hedges cannot use a beta
  2. BA single-factor regression hedge cannot be estimated from historical data
  3. CA single-variable regression hedge addresses only one source of yield curve movement, leaving exposure to other shape changes such as twists and curvatureCorrect
  4. DA single-factor regression hedge always produces a zero DV01 hedge

Explanation

A one-variable regression hedges mainly parallel-type co-movement with one instrument. Yield curve risk has several independent drivers (level, slope, curvature), which PCA captures by hedging multiple components.

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