Applying Error-Adjusted Hedging to Corporate Bond Portfolios

Abstract

This chapter presents empirical tests of alternative strategies for hedging a corporate bond portfolio. We find that the traditional implementation of these strategies does not lead to satisfactory results. On the contrary, an implementation considering the modeling errors can lead to satisfactory results, even though we clearly identified two different regimes. From 2000 to 2007, a hedging strategy based only on T-bond futures would have reduced the variance of the portfolio by circa 83.5%. On the contrary, in the years 2008 and 2009 properly hedging the dynamics of the credit spreads was of paramount importance. Unfortunately, the use of CDS contracts would have led only to marginal improvements. This unsatisfactory result seems to be due to liquidity and counterparty risk which led the CDS basis to display a significant volatility.