This study demonstrates how hedging methodologies can be evaluated in a modern risk management context and provides hedging effectiveness of dynamic hedge ratios. The results clearly indicate the superior performance of the time-varying hedge ratio, compared to the traditional duration-based constant ratio. Time-varying hedge ratio, which is estimated using CCC-GARCH model of Bollerslev (1990), shows a clear advantage in minimizing the variance of portfolio returns over a period of 10 years. The time-varying hedge ratio takes into account the conditional heteroskedasticity of the spot market yield curve. It provides an efficient measure for bond investors to maximize the value of their investments by changing positions in corresponding future markets of the US Treasury bonds according to the changes in actual yields of cash market. The results are robust in the sense that constant conditional correlation model takes account of the conditional heteroskedasticity present in the data of spot market.

Hedging is considered to be the most suitable tool to minimize the risk of the portfolio and to maximize the return, which is what every investor looks for. When interest rates rise, the cash position falls in value, thus a short position in futures market helps to offset the variations in the cash securities. An application of this approach might be a hedge placed on a bond dealer’s inventory. The length of time for which the inventory will be held by the dealer is unpredictable. The dealer therefore may wish to preserve the market value of the inventory at all times.

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