Explanation:
The regression framework, while useful, does not allow for complete control over the dispersion of the change in the nominal yield in relation to the change in the real yield. This is a significant limitation because the dispersion of changes in yields can have a substantial impact on the effectiveness of a hedge. If the dispersion is large, it means that the changes in the nominal yield for a given change in the real yield can vary widely, making it difficult to accurately predict and manage the risk associated with the hedge. This lack of control over the dispersion can lead to increased risk and potential losses, undermining the purpose of the hedge. Therefore, while the regression framework can provide valuable insights and help in managing risk, it is not a foolproof method and traders must be aware of its limitations.
Choice A is incorrect. The regression framework does indeed provide an estimation of the hedged portfolio's volatility. This is one of its strengths, not a limitation. It allows traders to understand the potential risk associated with their portfolio.
Choice B is incorrect. The ability to compare volatility with expected gain for decision making on the attractiveness of the risk-return structure is another advantage offered by regression analysis, not a limitation. It provides traders with valuable insights into potential returns relative to associated risks.
Choice C is incorrect. Regression analysis can be used to estimate average changes in nominal yield for given changes in real yield, allowing traders to adjust their DV01 hedge accordingly. This capability enhances its utility in hedging and does not represent a limitation.
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Q.1605 A regression framework is a statistical mechanism in the scope of finance, used widely to determine the strengths/weaknesses of a relationship between two variables (one dependent and the other independent). When used for hedging purposes, it provides many advantages. However, the downside is that:
A
it is able to give an estimation of the hedged portfolio’s volatility.
B
a comparison can be made by the trader of the volatility with expected gain for his verdict on the attractiveness of the risk-return structure.
C
the average change in the nominal yield for a given change in the real yield can be estimated by the trader and he can then make adjustments to the DV01 hedge accordingly.
D
no complete control can be made on the dispersion of the change in the nominal yield in relation to the change in the real yield.