HEDGING FROM PRINCIPAL COMPONENTS

Thomas Coleman
© September 2006
Corrected (for 2nd factor hedge) August 2008

Here are some ideas on a simple way to calculate hedges from the yield curve principal
components. Note, however, that I myself have not tested this extensively so I make no
warranties and it should be used with caution.

1) Calculate principal components for rates

a) These are shown in table 1 and repeated in columns 2 and 3 of table 2.
b) These represent the change in basis points corresponding to a 1 standard deviation shift in
the first and second principal components or factors for a hypothetical yield curve. In
this example the first principal component is a roughly parallel shift, with 6 month rates
going down by 2.0bp, 1 year rates by 2.2bp, etc. The downward shift in rates
corresponds to a rally in the market. The second principal component is a steepening
with 6 month rates down by 2.0bp and 30 year rates up by 2.0bp. This pattern of the first
two principal components being a roughly parallel shift and twist is an empirical
regularity across many currencies.
2) Calculate the DV01 / sensitivity of the portfolio to each of the yield curve points and to the
principal components.
a) The DV01 to each yield curve point is shown in the 4th column of table 2. For example
the DV01 in the 10yr bucket is 1,000 $/bp (i.e. if the market rallies and 10yr rates go
down by 1bp the portfolio makes $1,000).
b) The sensitivities to the principal components are shown at the bottom of the column
showing the portfolio DV01. The sensitivity to the 1st component is $7,300 for a 1
standard deviation move (rally in the market). This is calculated by taking the sum-
product of the DV01 times the change in bp (i.e. 100x2.0 + 500x2.2 + …) and changing
the sign.
3) Calculate the DV01 of the hedging instruments
a) The DV01 to a 1bp change in each rate is shown in columns 5-10 of table 2. For example
a $1mn position in a 10yr bond has a gain of $779 to a 1bp fall in 10yr rates and no gain
in response to a change in other rates.
b) The DV01 to a change in the 1st and 2nd principal components are shown at the bottom of
the column. For example $1mn of a 10yr bond has a DV01 to the 1st factor of $1,324 (= -
(-1.7x779)).
st
4) 1 Factor Hedges
a) Any single instrument (6 month, 1 year, etc.) can be used to hedge the 1st factor since the
1st factor assumes all rates move together, although by different amounts. (It might be
useful to measure the correlation of each instrument with the 1st factor but I have not
thoroughly explored this idea.)
b) The hedge amount for a specific instrument can be calculated by dividing the portfolio
sensitivity to the 1st factor by the instrument sensitivity to the 1st factor.
i) E.g. the 10yr hedge amount of -5.5mn = - 7,300 / 1,324. (The sign is changed since
hedging requires taking an offsetting position.)

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 ii) Note that the newly hedged portfolio (portfolio + 10yr hedge) now has sensitivity of
zero to the 1st factor and +2,234 to the 2nd factor, as shown in table 3 below.
5) 2nd Factor Hedges
a) To hedge the 2nd factor two instruments are necessary. The instruments should be chosen
so that they have zero sensitivity to the 1st factor. In this manner the 2nd factor hedges
can be applied without adjusting the 1st factor hedge.
b) My approach is to choose $1mn of the long end of a steepener and calculate the amount
of the short end so that the combination has zero sensitivity to the 1st factor.
i) For example, for long $1mn of 10yr then I will need short $3.52mn of 2yr to give
zero sensitivity to the 1st factor (-3.52 = -(1.00x779x-1.7)/(188x-2.0) or 1.00x779x-
1.7 – 3.52x188x-2.0 = 0)
c) Next calculate the sensitivity of this combination of instruments to the 2nd factor. In this
case it is a $1,110 loss for a 1 standard deviation move in the 2nd factor (steepening).
d) Finally, calculate how much of the combination is needed to hedge out the portfolio risk
(portfolio + 10yr hedge) to the 2nd factor.
i) In this case, +2.01 x (+$1mn 10s –3.52mn 2s). Here, +2.01 = -(+2,234/-1,110)
e) This gives a net overall hedge of (-7.1mn 2s and -3.5mn 10s) which is the combination of
the 1st factor hedge of -5.5mn 10s and the additional 2nd factor hedge of (-7.1mn 2s and
+2.0mn 10s).
6) Alternatively, one could calculate the 1st and 2nd factor hedges simultaneously, using two
hedge instruments and solving a set of simultaneous equations
a) As an example, say one used 2yr and 10yr bonds.
b) The equations to solve for hedging the portfolio first and second factor risk would be:
7,300 = N2 * Y12 * DV012 + N10 * Y110 * DV0110
-2,050 = N2 * Y22 * DV012 + N10 * Y210 * DV0110
where
N2 = number of 2yr bonds required
Y12 = 1st factor yield shift of 2yr yield
Y22 = 2nd factor yield shift of 2yr yield
etc.
7,300 = N2 * -2.0 * 188 + N10 * -1.7 * 779
-2,050 = N2 * -0.5 * 188 + N10 * +1.0 * 779
⇒ N2 = -7.12, N10 = -3.49
7) There are some delicate issues here. In particular, the principal components used here are for
the variance-covariance matrix of market movements, and thus provide a good
decomposition of market movements. But the actual portfolio may be quite different – in
particular the first few principal calculated from the rates variance-covariance matrix may not
be explain a high proportion of the portfolio variance. This simply means that hedging using
the market principal components would not hedge a large proportion of the portfolio’s
variance. (Speaking always, of course, of the historical variance of the market and the
portfolio.)

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Table 1 – Hypothetical Yield Principal
Components (bp for 1sd shift in factor)
Maturity 1st fact 2nd fact
0.5 2.0 -2.0
1 2.2 -1.0
2 2.0 -0.5
5 1.8 0.0
10 1.7 1.0
30 1.5 2.0

Table 2 – Calculating First Factor Hedges

Prin. Comp. Port. 1st fact hedges
Maturity 1st fact 2nd fact dv01 dv01/$mn
0.5 -2.0 -2.0 100 50 0 0 0 0 0
1 -2.2 -1.0 500 0 96 0 0 0 0
2 -2.0 -0.5 500 0 0 188 0 0 0
5 -1.8 0.0 1,000 0 0 0 438 0 0
10 -1.7 1.0 1,000 0 0 0 0 779 0
30 -1.5 2.0 1,000 0 0 0 0 0 1545
Sensitivity to 1st factor 7,300 100 211 376 788 1,324 2,318
$mn of hedge instrument -73.0 -34.6 -19.4 -9.3 -5.5 -3.1
Sensitivity to 2nd factor (2,050) 100 96 94 0 (779) (3,090)

Table 3 – Portfolio + Factor 1 Hedge – Calculating Second Factor Hedges

Prin. Comp. Port + 2nd fact hedges
Maturity 1st fact 2nd fact 10yr dv01 $mn dv01 $mn dv01 $mn dv01
0.5 -2.0 -2.0 100 0 0 0
1 -2.2 -1.0 500 0 0 0
2 -2.0 -0.5 500 -3.52 (662) -6.16 (1,158) 0
5 -1.8 0.0 1,000 0 0 -2.94 -1287.28
10 -1.7 1.0 (3,284) 1.00 779 0 0
30 -1.5 2.0 1,000 0 1.00 1,545 1.00 1545
Sensitivity to 1st factor 17 1 1 0
Sensitivity to 2nd factor 2,234 (1,110) (3,669) (3,090)
amount of steepener 2.01 0.61 0.72