LO 10.1: Explain the drawbacks to using a DVO 1-neutral hedge for a bond

LO 10.1: Explain the drawbacks to using a DVO 1-neutral hedge for a bond position.
A standard DVO 1-neutral hedge assumes that the yield on a bond and the yield on a hedging instrument rise and fall by the same number of basis points. However, a one-to- one relationship does not always exist in practice. For example, if a trader hedges a T-bond which uses a nominal yield with a treasury security indexed to inflation [i.e., Treasury Inflation Protected Security (TIPS)] which uses a real yield, the hedge will likely be imprecise when changes in yield occur. In general, more dispersion surrounds the change in the nominal yield for a given change in the real yield. Empirically, the nominal yield adjusts by more than one basis point for every basis point adjustment in the real yield.
DVO 1-style metrics and hedges focus on how rates change relative to one another. As mentioned, the presumption that yields on nominal bonds and TIPS change by the same amount is not very realistic. To improve this DVO 1-neutral hedge approach, we can apply regression analysis techniques. Using a regression hedge examines the volatility of historical rate differences and adjusts the DV01 hedge accordingly, based on historical volatility.
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Topic 10 Cross Reference to GARP Assigned Reading – Tuckman, Chapter 6
R e g r e s s i o n H e d g e

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