THE USE OF TERM STRUCTURE INFORMATION IN THE HEDGING OF JAPANESE GOVERNMENT BONDS

This paper employs the Kalman filter to explore the impact of term structure variables in the hedging of Japanese Government Bonds (JGBs) with treasury futures. The term structure factors (level parameter 0 β , slope parameter 1 β , and curvature parameter, 2 β ) are based on Nelson and Siegel (1987) model. The out-of-sample hedging performance is also provided by moving window technology. The empirical results show the existence of significant relationships among the term structure factors, the earlier hedge ratio, and the optimal hedge ratio. However, the time-varying hedge ratio (which includes the term structure variables from the information set) did not provide good out-of-sample hedging effectiveness. Nevertheless, the out-of-sample results did demonstrate that the performance of the timevarying hedge ratio with term structure variables is better than a hedge ratio with a naive hedge or OLS model in the 7–10-year Japanese Government Bond index.