Introduction

Duration-based hedging strategies have proven to be valuable tools in managing interest rate risk. However, it’s crucial to recognize that these strategies come with inherent limitations that can impact their effectiveness in certain scenarios. In this chapter, we will delve into the various limitations associated with using a duration-based hedging strategy and provide insights into when these limitations might become significant.

Limitation of Duration-Based Hedging Strategy

• Non-Parallel Shifts in the Yield Curve: Duration-based hedging assumes that the yield curve shifts in a parallel manner, meaning that all maturity points move by the same amount. However, in reality, yield curves often experience non-parallel shifts where different segments of the curve move by varying degrees. In such cases, a duration-based strategy may not adequately protect against risk exposure. For instance, if short-term rates rise more than long-term rates, a portfolio with a fixed-duration hedge could still suffer losses.

• Convexity Effects: While duration captures the linear relationship between bond prices and yield changes, it doesn’t fully consider the curvature of the price-yield curve. Convexity plays a significant role when interest rates change significantly. When rates fall, the convexity effect can amplify gains, but when rates rise, it can lead to greater losses than anticipated. Duration-based hedges often overlook this dynamic.

• Changes in Yield Curve Shape: Duration-based strategies struggle to account for shifts in the shape of the yield curve. If the curve becomes steeper or flatter, the relationship between changes in bond prices and changes in yields can deviate from the assumptions underlying the duration metric. As a result, the hedging effectiveness might deteriorate.

• Embedded Options: Many bonds, such as callable bonds, have embedded options that allow the issuer to call back the bonds before maturity. These options significantly affect the bond’s cash flows in response to changes in interest rates. Duration-based hedging may not appropriately handle the complexities introduced by these embedded options, leading to suboptimal risk management.

• Liquidity Constraints: Implementing a duration-based hedging strategy often involves trading in the futures or options markets. In less liquid markets, executing trades at desired prices can be challenging, potentially causing the strategy to underperform due to unfavorable execution.