Litterman and Scheinkman (1991) showed that even a duration immunized fixed-income portfolio (neutral) can bear great losses and, therefore, propose hedging the portfolio using a principal component's analysis. The problem is that this approach is only possible when the interest rates are observable. Therefore, when the interest rates are not observable, as is the case of most international and domestic debt markets in many emerging market economies, it is not possible to apply this method

more »

... tly. The present study proposes an alternative approach: hedging based on factors of a parametric term structure model. The immunization done using this approach is not only simple and efficient but also equivalent to the immunization procedure proposed by Litterman and Scheinkman when the rates are observable. Examples of the method for hedging and leveraging operations in the Brazilian inflation-indexed public debt securities market are presented. This study also describes how to construct and to price portfolios that replicate the model risk factors, which makes possible to extract some information on the expectations of agents in regards to future behavior of the interest rate curve.