hey guys…trying to get some comfort zone on this one, not sure if i understand this correctly, basis risk adjustment is used to reflect the imperfect correlation between the hedged position and the future underline during a cross hedge. Yield beta captures the correlation of the change in yield between the hedged position and the future underline, which essentially also reflect the fundamental difference between the hedged position and the future. what is the diff between these two adjustment?
You mean hedge ratio (not basis risk) is the adjustment needed when you are doing a cross hedge because the hedged position and hedging instrument are exposed to different risk factors (like interest rates) Yield beta is the adjustment needed to account for the change in spread between hedging instrument and hedged position. For example, if historically the spread has been constant, then yield beta=1 Is that what you are referring to?
Thanks Mik for the feed back. I guess my question was since yield beta gives you the relative relations of the yield change, which essentially is also the relations between their price change.(since yield and price are inversely related) What is the fundamental difference between this adjustment and the hedge ration when measuring the hedge effectiveness?
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>yiled beta
Thanks Mik, wouldn’t a change in the yield/yield ratio between two bonds effectively change their price/price ratio too?
mike82 makes a lot of sense to me too.
There are three instruments here. 1. What we want to hedge (let’s say a bond issued by Ford) 2. Future contract on the Treasury Bond 3. Treasury Bond, on which there is a future contract. Relationship between 1 and 3 is measured by hedge ratio. Relationship between 2 and 3 is measured by yield beta and generally, it is one.
I copied it Curriculum Vol 5: Hedge Ratio: The relationship of the quantity of an asset being hedged to the quantity of the derivative used for hedging. Yield Beta: A measure of the sensitivity of a bond’s yield to a general measure of bond yields in the market that is used to refine the Hedge Ratio. Yield on bond to be hedged = a + b*(Yield on CTD bond) + e, where b is the yield beta. Jay_X may refer to the hedge ratio in fixed income: Hedge Ratio = b*cf*(Dh*Ph)/(Dctd*Pctd) PS. Hedge ratio in currency: 0.5 means that 50% of the equity asset is hedged for exchange rate risk. Hedge ratio in options = 1/Delta. —