Regression-Based Hedging and Volatility Weighting

The DV01 hedge assumes that when the yield on the security you own moves by 1 bp, the yield on the hedging instrument moves by exactly 1 bp too. Key-rate analysis relaxes this by allowing different buckets to move independently. But both approaches still take the size of the move as given — they don't ask how much does hedge yield typically move when the target yield moves? In practice, a 20-year Treasury yield moves by a different number of basis points than a 30-year yield for any given shock. If that ratio is consistently 1.1 rather than 1.0, then a pure DV01 hedge systematically under-hedges.

Volatility-weighted hedging corrects for this by scaling the hedge ratio by the ratio of the two securities' yield volatilities. Regression-based hedging goes further: it estimates the relationship between yield changes using historical data, allowing for an imperfect correlation between them. The regression beta — the slope from regressing the hedged yield change on the hedge yield change — is the risk weight.

Learning objectives. By the end of this note you should be able to: