Comparison of the Principal Component· Based Fixed Income Hedging Strategies

This study analyses and compares various Principal Component-based methods of fixed income security immunization. We show that the methods are effective in terms of reducing the volatility of the security returns; however, none of the Principal Component-based techniques outperforms the mean-variance optimization. We conclude that the Principal Component-based immunization is more effective when including all the available underlying securities in the portfolio instead of hedging with the limited number of selected underlying securities. We show that the Principal Component-based methods are not effective for hedging short-term securities. We conclude that application of the Principal Component-based immunization techniques requires balancing the contrary effects of the model error and the estimation error on the results.