Model Selection and Hedge Ratios: Hull-White vs. Black

Link to Financial Engineering News article.

This paper was the result of a vain attempt to model interest rate caps and swaptions with the Hull-White model, as opposed to a simple Black model.  It didn't work, but provides a cautionary tale when trying to implement the latest and greatest models for a bunch of traders.  Bottom line: a foolish consistency is the hobgoblin of small-minded quants.  

Minimizing Basis Risk from Non-Parallel Shift in the Yield Curve Part II: Principal Components

Reprinted with permission from The Journal of Fixed Income, June 1997 (with Jerry Hanweck, Jr.).

This article compares principal components-based hedges with covariance-based key rate duration hedges. It finds very similar results for the methods with one-or two principal components, but deteriorating performance for the third component, indicating significant instability of higher-order parameter estimates in principal components models.

Minimizing Basis Risk from NonParallel Shifts in the Yield Curve

Reprinted with permission from The Journal of Fixed Income, June 1996 (with Jerry Hanweck, Jr.).

The aim is to construct a hedge that minimizes the variance of the hedged portfolio within a class of hedges, given the covariances among the hedging securities and the portfolio. The key-rate covariance hedge provides a significant increase in hedge efficiency over duration or yield beta approaches, and does not require highly sophisticated statistics.