Hi, is it better practice when hedging a callable bond to hedge based on bond duration, or time to call, rather than actual maturity? Or does the probabilty of call need to be taken into account somehow? Many thanks,
A first order hedge should be based on option-adjusted duration, which will incorporate the (risk neutral) call probability. I suspect Gmike though it a bit too obvious that you need to somehow account for the call.
Thanks much, and agreed. I guess what I was also asking with probability of call was beyond the first order delta hedge - in other words, hedging the callable with an optional-type structure. How have you seen this done in practice?