January 21st, 2011, 1:01 pm
For the sake of discussion, assume I am dynamically replicating a cap/floor contract with a maturity of fifteen years. So I am trying to replicate a series of rate contingent cash flows occurring over fifteen years. (My real situation has considerably more rate-gamma than this example, however.)If I only rely on my factor model, I can theoretically trade any three securities to dynamically hedge: 2-10-30, 5-15-20, 1-2-3, etc. This highly-compact trading is a bad idea because I am completely dependent upon my model assumptions.If I only rely model-independent key rate durations, I might wind up trading all the cannonical tenors 1-2-3-4-5-7-10-15-20-30. This is more trading than I really need and creates expense and "maintenance issues".Where is the middle way?