Financial Review EFA Eastern Finance Association The Financial Review 33 (1998) 61-80 A Futures Duration-Convexity Hedging Method Robert T. Daigler* Mark Copper Florida International University Wayne State University* Abstract A duration-based hedge ratio is the conventional method to hedge against price changes of a fixed-income instrument. However, the relationship between bond prices and interest rates is nonlinear, creating a convexity effect. Moreover, term structure changes often are nonparallel in nature, which causes imperfect hedges for the duration-based hedging model. One solution to these problems is to dynamically change the duration-based hedge ratio; however, this procedure is costly and is not effective when jumps in prices occur. A superior solution is to develop a two-instrument hedge ratio that simultaneouslyhedges both duration and convexity effects. This paper first presents such a two-instrument hedge ratio and then we examine its effectiveness. The simulation results show that this duration-convexityhedge ratio is vastly superior to alternative hedge ratio methods for both simple and complex changes in the term structure. Keywords: futures, hedging, duration, convexity JEL classifications: G 13 1. Introduction A popular measure of the volatility of a fixed-income instrument is the (Ma- caulay) duration. Since duration is proportional to the slope (derivative) of the *Corresponding author: Department of Finance, BA 206, College of Business, Florida International University, Miami, Florida 33199; Phone: (305) 348-3325, Fax: (304) 348-3278, E-mail: DAIGLERR@- FItJ.EDU The authors would like to thank W. Brian Barrett and Eric W. Stiles for helpful comments on an earlier draft of this paper and Gerald Bierwag for his insights to the problem. 61