Short-term Hedging with Futures Contracts by 0KEnhD2X


									              The Academy of Economic Studies Bucharest
             DOFIN - Doctoral School of Finance and Banking

 Short-term Hedging with Futures Contracts

Supervisor: Professor Moisă Altăr
                                                MSc Student Iacob Călina-Andreea

                                    July 2010

I. The use of the optimal hedge ratio

II. Objectives

III. Literature review

IV. Methodology

V. Data description

VI. Estimation results

VII. Conclusions

I. The use of the optimal hedge ratio
Hedging with futures contracts:
       A hedger who has a long (short) position in a spot market and wants to lock
        in the value of its portfolio can take an opposite position in a futures market
        so that any losses sustained from an adverse price movement in one market
        can be in some degree offset by a favorable price movement on the futures

-       Maturity mismatch: hedging instrument vs. hedging period
-       Less than perfect correlation: futures & spot markets
-       Proxy hedge: hedging a portfolio with a futures on correlated a
                      stock index
-       Basket Hedge: hedging a portfolio with a portfolio of futures

II. Objectives

 Assess the relationship between the Romanian spot and futures markets

 Estimate the optimal hedge ratio (minimum variance hedge ratio)

Test the out-of-sample efficiency of the hedging strategies considered

III. Literature review
        The optimal hedge ratio has been a subject of interest for economic and econometric
        studies for many years. The focus shifting from establishing the most appropriate
        hedging criteria to finding the best econometric estimation method to estimate the
        optimal hedge ratio. Chen, Lee and Shrestha (2002) and Lien and Tse (2002) provide
        an overview of the specialised literature on this topic.
Approaches to setting the hedging objective:
       minimum variance hedge ratio;
       mean-variance framework;
       the use of different utility functions in the mean-variance framework;
       maximise the Sharpe ratio;
       minimise the mean Gini coefficient;
       minimisation of the generalized semi-variance or higher partial moments.

Numerous approaches to the estimation of the hedge ratio ranging from the OLS
  method to sophisticated GARCH specifications.

IV. Methodology
There is a maturity mismatch and the hedge position is closed at some time t<T, where T is the
expiry date of the futures.

       Let Rs,t and Rf,t denote the one-period returns of the spot and futures positions, respectively.

       The return on the portfolio, Rh, is given by:

       Rh,t=Rs,t – hRf,t                                                                          (1)

       Minimising the portfolio risk:

                                                                                                  (2)

       The minimum variance hedge ratio (MVHR):


IV. Minimum variance hedge ratio

       I. OLS
                                                                                    (4)

       II. Bivariate GARCH     –    the BEKK parameterisation proposed by Engle and
        Kroner (1995)
                                                                                    (5)

                                                                                    (6)

  where                            Ht is a (2x2) conditional variance-covariance matrix
specified as:
                                                                                     (7)

       where matrixes A1 and G1 are diagonal.

IV. Minimum variance hedge ratio
Ederlington measure (1979)
The risk reduction was measured as:

σu and σh are standard deviations of the unhedged and hedged portfolio, respectively.

   V. Data description
BSE futures
market in 2009
(Source: Annual report)

SMFCE futures
market in 2009
(Source: Annual report)

V. Data description
    SIF Oltenia – SIF5
- for end-of-day spot prices
     (SIF5 is traded on the Bucharest Stock
     Exchange (BSE))
- for end-of-day prices for the
     futures contract (DESIF5 trading started in
     2004 on the Futures exchange in Sibiu
     (Sibex) and since 2008 it is also traded on
     the BSE)

Period 3 January 2005 – 31 March 2010:
-  daily spot and futures prices – 1322 daily observations;
-  the futures series was built using the closest contract to maturity and switching to the next closest to
   maturity contract 7 days before expiry (only contracts traded on Sibex have been included in the
-  weekly spot and futures prices (Wednesday prices) - 266 weekly observations;
Period 1 April 2010 – 25 June 2010: used for hedging efficiency testing;
-  60 daily prices & 12 Wednesday prices;

V. Data description

V. Data description - cointegration
     Cointegration test for daily   Cointegration test for weekly
      Spot and Futures prices         Spot and Futures prices

VI. Estimation results - OLS
     Daily Spot and Futures prices   Weekly Spot and Futures prices

VI. Estimation results - BEEK
     Daily Spot and Futures prices

VI. Estimation results - BEKK
     Weekly Spot and Futures prices

VI. Estimation results
For each hedging strategy :

VI. Estimation results

Static hedge

VI. Estimation results
 Dynamic hedge - weekly futures position changes – 1 April -23 June 2010

VII. Conclusions

-    The best hedging strategy was the naïve hedge which incorporates also the benefit of
     reduced transaction costs.
-    Weekly data provides more information when constructing short term hedge
     strategies but using fewer observations may introduce instability into the estimates.
-    All hedging methods considered can effectively reduce risk. The MVHR obtained
     were close to unity, the higher the hedge ratio the more efficient the hedge.
-    As in the case of many other papers on this subject, result are very much data
     specific especially due to the fact that the futures market in Romania is still in
     development. Only in the last couple of year some new products were launched
     showing an increased interest of investors in alternative investment solutions.

-    Alexander, C. (2008), Futures and Forwards, Market Risk Analysis Volume III - Pricing, Hedging and Trading Financial Instruments, 101-
-    Alexander, C. and Barbosa, A. (2007), “The impact of electronic trading and exchange traded funds on the effectiveness of minimum
     variance hedging”, Journal of Portfolio Management, 33, 46−59.
-    Alexander, C. and Barbosa, A. (2007), “Effectiveness of Minimum-Variance Hedging”, The Journal of Portfolio Management, 33(2), 46-
-    Baillie, R. and Myers (1991), “Bivariate GARCH Estimation of the Optimal Commodity Futures Hedge”, Journal of Applied
     Econometrics, 6(2) , 109-124.
-    Brooks, C. (2008), Modeling volatility and correlation, Introductory Econometrics for Finance, 428-450.
-    Brooks, C., Henry, O. T., and Persand, G. (2002), “The effect of asymmetries on optimal hedge ratios”, Journal of Business, 75, 333−352.
-    Chen, S., C. Lee, and Shrestha, K. (2003), “Futures Hedge Ratios: A Review”, The Quarterly Review of Economics and Finance, 43, 433-
-    Ederington, L. H. (1979), “The hedging performance of the new futures markets”, Journal of Finance, 34, 157−170.
-    Engle, R. F. and Kroner, K. F. (1995), “Multivariate simultaneous generalized ARCH”, Econometric Theory, 11, 122–50.
-    Kavussanos, M. and Visvikis, I (2008) ,”Hedging effectiveness of the Athens stock index futures contracts”, The European Journal of
     Finance, 14: 3, 243 – 270.
-    Laws, J. and Thompson, J. (2005), “Hedging effectiveness of stock index futures”, European Journal of Operational Research 163 177–
-    Lien, D. (2006), “A note on the hedging effectiveness of GARCH models”, Working Paper, College of Business, University of Texas at
     San Antonio.
-    Lien, D., and Y.Tse (2002), “Some Recent Developments in Futures Hedging”, Journal of Economic Surveys, 16 (3), 357-396.
-    Lien, D., and Shrestha. K. (2008), “Hedging effectiveness comparisons: A note”, International Review of Economics and Finance 17,
-    Lien, D., and Yang. Li. (2008), “Hedging with Chinese metal futures”, Global Finance Journal, 19 123–138
-    Myers, R. (1991), “Estimating time-varying optimal hedge ratios on futures markets”, Journal of Futures Markets, 11, 39−53.


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