Financial Education

Financial futures markets typically use one instrument to hedge a position. For example, a 10-year note future might be used to hedge a position in 10-year Treasury securities. However, such hedges can often be imperfect due to the structure of futures markets. A futures position can be satisfied by delivery of a wide range of bonds, and the cheapest to deliver (CTD) option may have qualities that differ significantly from the bond being hedged.

In the January/February 2008 Financial Analysts Journal, Lawrence Morgan addresses this issue and provides an example: in February 2007, the 10-year T-note was yielding 4.625%, but the CTD for the June 2007 10-year note futures was the 4.25% November 2013 note - a 7 year instrument.

Morgan examines whether combination hedges, made by combining two hedging instruments, would provide a better match. Leschhorn (2001) developed and tested an approach for the German bond market in which the weights of the two hedging instruments were determined by their yield differentials. Morgan notes that this approach can frequently result in unstable hedge ratios.

Morgan extends the analysis to combination hedges weighted by option-adjusted and non-option adjusted modified durations, and finds that in general option-adjusted modified duration weighted combination hedges performed best.

For more information, see all articles on: Active Management, Derivatives, Fixed income investments, Futures, Hedge Funds, Investing in bonds, Investment Returns, Performance Measurement, Risk Management

See also:

Investing in Commodities

Investment Advisory Fees

What is a Bond?

Types of Alternative Investments

Comprehensive Income