Why projected basis values is a source of hedging error?

CFA Level III
#1

Hi everyone,

On page 120 Fixed Income book, it says that The three major sources of hedging error includes projected basis values, can someone please explain why this is a hedging error source?

Is it based on choosing the futures maturity to coincide with the maturity of the underlying bond?

Thanks

#2

basis = difference between spot price and (futures) forward price.

if you expect the futures price to be higher or lower than the spot price at the time of lifting the hedge - you would over estimate or underestimate the amount of hedge required…

is what I think

#3

thanks cpk!

#4

If you expect the futures price > spot… you would over hedge = risk…

Any idea why you would over hedge?

If your long the asset and you sell to hedge… is it because you would want to lock in the higher selling price? Thanks.

Expect FP > (

#5

say you had $100 of a portfolio. Your # of futures contracts needed to hedge that portfolio =

hedge Ratio = (Duration of Portfolio * Value of Portfolio)/(Duration of Futures contract * Price of futures contract) * Conversion Factor for CTD bond.

Price of futures contract which is on the denominator is what we are discussing with the projected basis value.

If that futures value is higher than the actual value - your hedge ratio is lower than what is actually needed. So you are going to be actually hedging for your $100 portfolio with fewer futures contracts than you actually need.

Not sure if I am explaining this right…