Calculating the optimal hedge ratio: constant, time varying and the Kalman Filter approach

A crucial input in the hedging of risk is the optimal hedge ratio – defined by the relationship between the price of the spot instrument and that of the hedging instrument. Since it has been shown that the expected relationship between economic or financial variables may be better captured by a time varying parameter model rather than a fixed coefficient model, the optimal hedge ratio, therefore, can be one that is time varying rather than constant. This study suggests and demonstrates the use of the Kalman Filter approach for estimating time varying hedge ratio – a procedure that is statistically more efficient and with better forecasting properties.

[1]  Y. Tse,et al.  Evaluating the hedging performance of the constant-correlation GARCH model , 2002 .

[2]  P. Holmes,et al.  The hedging effectiveness of stock index futures: evidence for the FTSE-100 and FTSE-mid250 indexes traded in the UK , 2001 .

[3]  A. Harvey Time series models , 1983 .

[4]  Robert J. Myers,et al.  Bivariate garch estimation of the optimal commodity futures Hedge , 1991 .

[5]  Dimitrios V. Vougas,et al.  Hedge ratios in Greek stock index futures market , 2004 .

[6]  K. Kroner,et al.  Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures , 1993, Journal of Financial and Quantitative Analysis.

[7]  Sheng-Syan Chen,et al.  Futures hedge ratios: a review , 2003 .

[8]  Robert F. Engle,et al.  Advances in Econometrics: The Kalman filter: applications to forecasting and rational-expectations models , 1987 .

[9]  Haiyan Song,et al.  Forecasting UK house prices: A time varying coefficient approach , 1997 .

[10]  D. Lien,et al.  The effect of the cointegration relationship on futures hedging: A note , 1996 .

[11]  Hans Byström,et al.  The hedging performance of electricity futures on the Nordic power exchange , 2000 .

[12]  P. Holmes Ex ante hedge ratios and the hedging effectiveness of the FTSE-100 stock index futures contract , 1995 .

[13]  P. Perron,et al.  The Great Crash, The Oil Price Shock And The Unit Root Hypothesis , 1989 .

[14]  The pricing of stock index futures spreads at contract expiration , 2002 .

[15]  Eduardo Rossi,et al.  Hedging interest rate risk with multivariate GARCH , 2002 .

[16]  Andrew Harvey,et al.  Trends, Cycles and Autoregressions , 1997 .

[17]  Lorne N. Switzer,et al.  Bivariate GARCH estimation of the optimal hedge ratios for stock index futures: A note , 1995 .

[18]  I. Moosa The Sensitivity of the Optimal Hedge Ratio to Model Specification , 2003 .

[19]  Hedging With International Stock Index Futures: An Intertemporal Error Correction Model , 1996 .

[20]  Robert J. Myers,et al.  Generalized Optimal Hedge Ratio Estimation , 1988 .

[21]  A. Sim,et al.  Dynamic Hedging Effectiveness in South Korean Index Futures and the Impact of the Asian Financial Crisis , 2001 .

[22]  A. Frino,et al.  The Lead–lag relationship between stock indices and stock index futures contracts : further Australian evidence , 1999 .

[23]  K. Lim Portfolio hedging and basis risks , 1996 .

[24]  A. Hatemi-J Is the Government's intertemporal budget constraint fulfilled in Sweden? An application of the Kalman filter , 2002 .

[25]  Cheng-Few Lee,et al.  Hedging with the NIKKEI Index Futures: Conventional Model Versus Error Correction Model , 1996 .

[26]  David V. Pritchett Econometric policy evaluation: A critique , 1976 .

[27]  W. Chou,et al.  Hedging with the Nikkei index futures: The convential model versus the error correction model , 1996 .

[28]  Peter C. B. Phillips,et al.  Bayesian model selection and prediction with empirical applications , 1995 .

[29]  A. Ghosh The Hedging Effectiveness of ECU Futures Contracts: Forecasting Evidence from an Error Correction Model , 1995 .

[30]  A. Frino,et al.  The Lead-Lag Relationship between Equities and Stock Index Futures Markets Around Information Releases , 2000 .

[31]  Donald Lien,et al.  Estimating multiperiod hedge ratios in cointegrated markets , 1993 .

[32]  Stephen Figlewski,et al.  Estimation of the Optimal Futures Hedge , 1988 .