Forward Curve Bias and Optimization Errors

Abstract

We derive optimal hedging ratios for interest rate risk under different assumptions that underpin the relationship between the forward rate and the expected future spot rate. In some instances, full hedging is optimal, and the conditions for the optimality of a partial hedge are identified. Less hedging (more floating debt in our model) is more optimal under the liquidity preference model than under the unbiased expectations hypothesis. This indicates that in times of higher preference for liquidity less hedging is optimal. Higher preference for liquidity correlates with larger term spreads (a steeper yield curve) and periods of monetary easing. Comparison of the analytical results with historical data indicates that partial hedging for interest rate risk is generally preferable over full hedging strategies with some exceptions. Lastly, the paper shows the role of market timing on hedging decisions.

Keywords: Hedge Ratios, Forward Rate, Expected Spot Rate, Profit Maximization, Expected Utility

JEL Classification: D81, D84, G14