Alternate Hedge Ratios for Bonds Subject to Credit Risk
Frank Skinner, New York University

The project paper introduces eight new methods for computing hedge ratios for credit-risky bonds. It then conducts a horse race to determine which, if any, of these methods performs better than hedge ratios based on modified Macaulay duration and modified Macaulay duration with convexity. The results suggest that a pure interest rate hedge ratio consistently outperforms the modified Macaulay methods for high credit quality portfolios. For lower quality bonds, the results show that a hedge that employs a corporate index as the hedging instrument performs best. Finally, the results show that most of the benefits of diversification are achieved for relatively small portfolios of nine bonds. (Accepted Fall 1996.)