Immunization With Consistent Term Structure Dynamics

We show that improved hedging of bond portfolios can be achieved by matching generalized durations that are parametrized according to a parsimonious yield curve shape which is dynamically consistent with a new term structure model with stochastic level, slope, and curvature factors. Performance deteriorates if matching basic durations, or generalized durations based on unrestricted factor models or dynamically inconsistent curve shapes. The dynamic consistency approach accommodates standard affine models as the special case in which locally deterministic factors are constant through time, corresponding to the intercept in the affine yield, but hedging performance deteriorates under this restriction