When constructing a hedge and evaluating sources of hedging error, what is the difference between BASIS RISK and YIELD BETA. They both seem to relate to the correlations between the asset to hedge and the heding instrument. How are these different?
I think basis risk is the risk of prices ( between hedged position and the hedging instrument itself ) diverging on a fundamental basis due to interest rate changes.
Yield Beta is a similar term but refers to yields , not prices . The two are not the same .
For example let’s say you have a portfolio of bonds and use an interest rate future to hedge it.
How well the futures contract price mimics your actual bond portfolio value is the measure of basis risk. That would casue you to change hedge ratios ( and incur costs )
How well the futures contract tracks a benchmark such as treasury yield would be yield beta . That would indicate a sensitivity to rate changes and may be different between futures contract and your portfolio. The two express the same thing but one is a direct measure ( basis risk ) while one is an ex-ante measure indicating how often you might have to change or adjust hedge using the futures contract .
No, yield beta means CTD change 1%, how much change in the hedged asset(for example corporate bond portfolio)
OK you are right . on page 120 of volume 4 they do say the Yield Beta is estimated by regressing the CTD bond against the bond being hedged to determiine the yield sensitivity . It is used to determine the number of contracts to buy/sell in the futures market to perform the hedge .
The relationship btw price/price and btw yield/yield is not the same : Adj for price/price relationship (minimize basis risk) --> hedge ratio. Adj for yield/yield relationship --> yield beta.
One of the components of hedge ratio calculation is the yield beta because it measures the actual sensitivity of the bond being hedged to the CTD bond that will be delivered / accepted on expiry .The other components are the Futures price , and the conversion ratio. If it is an international bond , there may be a country beta as well. ( not sure if this is included in yield beta or it is a seperate term )