Adjusting Principal Component Analysis for Model Errors

Abstract

Several papers which tested alternative ways of hedging against yield curve risk reported that models capturing the dynamics of the yield curve better do not necessarily lead to better hedging. We claim that the main reason for these counterintuitive observations could have been the level of exposure to the model errors and tested a generalized model of PCA-hedging which controls the overall exposure to these errors. The results we obtained both for bond-based and for swap-based hedging clearly confirm our claim. Controlling the exposure to model errors leads to an average reduction in the hedging errors of 35%. An additional, important advantage of controlling the exposure to model errors is a substantial reduction in the transaction fees implied by the hedging strategies.