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Hedging the black swan: Conditional heteroskedasticity and tail dependence in S&P500 and VIX

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  • Hilal, Sawsan
  • Poon, Ser-Huang
  • Tawn, Jonathan

Abstract

The recent financial crisis has accentuated the fact that extreme outcomes have been overlooked and not dealt with adequately. While extreme value theories have existed for a long time, the multivariate variant is difficult to handle in the financial markets due to the prevalent heteroskedasticity embedded in most financial time series, and the complex extremal dependence that cannot be conveniently captured by a single structure. Moreover, most of the existing approaches are based on a limiting argument in which all variables become large at the same rate. In this paper, we show how the conditional approach of Heffernan and Tawn (2004) can be implemented to model extremal dependence between financial time series. We use a hedging example based on VIX futures to demonstrate the flexibility and superiority of the conditional approach against the conventional OLS regression approach.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 35 (2011)
Issue (Month): 9 (September)
Pages: 2374-2387

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Handle: RePEc:eee:jbfina:v:35:y:2011:i:9:p:2374-2387

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Web page: http://www.elsevier.com/locate/jbf

Related research

Keywords: Financial time series Extreme value theory Extremal dependence structure Downside risk Optimal hedge ratio;

References

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  1. Beine, Michel & Cosma, Antonio & Vermeulen, Robert, 2010. "The dark side of global integration: Increasing tail dependence," Journal of Banking & Finance, Elsevier, vol. 34(1), pages 184-192, January.
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  11. Ser-Huang Poon, 2004. "Extreme Value Dependence in Financial Markets: Diagnostics, Models, and Financial Implications," Review of Financial Studies, Society for Financial Studies, vol. 17(2), pages 581-610.
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Cited by:
  1. Cheng, Jun & Ibraimi, Meriton & Leippold, Markus & Zhang, Jin E., 2012. "A remark on Lin and Chang's paper ‘Consistent modeling of S&P 500 and VIX derivatives’," Journal of Economic Dynamics and Control, Elsevier, vol. 36(5), pages 708-715.

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