Case study: Comparing effectiveness methodologies

The dollar-offset method is arguably the simplest approach to assessing ineffectiveness, but it is also the most sensitive. Effie Miskouri, a researcher with Centre for Quantitive Finance (CQF) at the Imperial College in the UK working with Cygnifi (a risk ASP), created an example of a simple swap and tested its effectiveness as a hedge based on the dollar offset, 80-120 ratio and regression analysis.

The results (see below) demonstrate that regression (or statistical analysis) is likely to smooth out more of the ineffectiveness generated, even in simple hedges, than the other two methods.

An example using a swap paying three-month LIBOR and receiving quarterly fixed to hedge a one-month LIBOR stream, both with start and maturity dates 01/01/00 and 01/01/02 respectively, highlights the importance of effectiveness choices, Ms. Miskouri points out. The swap/hedge were tested and the following results were obtained:

The results obtained indicated that this particular hedge was effective only when performing the regression analysis on quarterly MTM changes. All the other tests yielded a non-effective hedge. This example, says Ms. Miskouri, illustrates a key point about implementing effectiveness tests: “Different results yield not only from different methods but also from choosing different time periods for the same tests.”