Immunization in the Treasury market using consistent term structure dynamics *

Abstract

We show that improved hedging of interest rate risk can be achieved by matching generalized durations, provided sufficient structure is in place. Using the standard three factors is insufficient. Hedging performance can be enhanced using parsimoniously parametrized factor loadings, but these must adhere to dynamically consistent shape of the yield curve. Strongest empirical performance is achieved using a new term structure model with stochastic level, slope, and curvature factors. Gains are of the order one half or better in RMSE terms in most cases. Performance deteriorates if matching basic durations, or generalized durations with loadings corresponding to unrestricted, dynamically inconsistent, or affine curve shape.

Keywords: Hedging, generalized duration, parsimonious yield curve shape, dynamic consistency, Treasury bonds JEL Classification: C32, C38, E43, G11, G12