Robust estimation of the optimal hedge ratio

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Robust estimation of the optimal hedge ratio

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dc.contributor.author Harris, Richard D. F. en_GB
dc.contributor.author Shen, Jian en_GB
dc.contributor.department University of Exeter en_GB
dc.date.accessioned 2008-07-04T09:36:41Z en_GB
dc.date.accessioned 2011-01-25T10:16:21Z en_US
dc.date.accessioned 2013-03-19T15:44:08Z
dc.date.issued 2003 en_GB
dc.description.abstract When using derivative instruments such as futures to hedge a portfolio of risky assets, the primary objective is to estimate the optimal hedge ratio (OHR). When agents have mean-variance utility and the futures price follows a martingale, the OHR is equivalent to the minimum variance hedge ratio,which can be estimated by regressing the spot market return on the futures market return using ordinary least squares. To accommodate time-varying volatility in asset returns, estimators based on rolling windows, GARCH, or EWMA models are commonly employed. However, all of these approaches are based on the sample variance and covariance estimators of returns, which, while consistent irrespective of the underlying distribution of the data, are not in general efficient. In particular, when the distribution of the data is leptokurtic, as is commonly found for short horizon asset returns, these estimators will attach too much weight to extreme observations. This article proposes an alternative to the standard approach to the estimation of the OHR that is robust to the leptokurtosis of returns. We use the robust OHR to construct a dynamic hedging strategy for daily returns on the FTSE100 index using index futures. We estimate the robust OHR using both the rolling window approach and the EWMA approach, and compare our results to those based on the standard rolling window and EWMA estimators. It is shown that the robust OHR yields a hedged portfolio variance that is marginally lower than that based on the standard estimator. Moreover, the variance of the robust OHR is as much as 70% lower than the variance of the standard OHR, substantially reducing the transaction costs that are associated with dynamic hedging strategies. en_GB
dc.identifier.citation Journal of Futures Markets, Vol. 23 ,Issue 8, p. 799 – 816 en_GB
dc.identifier.doi 10.1002/fut.10085 en_GB
dc.identifier.uri http://hdl.handle.net/10036/30954 en_GB
dc.language.iso en en_GB
dc.publisher Wiley en_GB
dc.relation.ispartofseries Accounting Working Papers en_GB
dc.relation.ispartofseries 02/06 en_GB
dc.relation.url http://www3.interscience.wiley.com/journal/34434/home en_GB
dc.relation.url http://www.sobe.ex.ac.uk/accounting/papers/0206.pdf en_GB
dc.subject Optimal hedge ratio en_GB
dc.subject Hedging en_GB
dc.subject Robust estimation en_GB
dc.subject Futures en_GB
dc.subject FTSE 100 en_GB
dc.subject Stock index en_GB
dc.title Robust estimation of the optimal hedge ratio en_GB
dc.type Article en_GB
dc.date.available 2008-07-04T09:36:41Z en_GB
dc.date.available 2011-01-25T10:16:21Z en_US
dc.date.available 2013-03-19T15:44:08Z
dc.identifier.issn 02707314 en_GB
dc.identifier.issn 10969934 en_GB
dc.description Pre-print of the article was published in the Accounting Working Papers series (ISSN 1473 2920) en_GB
dc.identifier.journal Journal of Futures Markets en_GB


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