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Stochastic optimal hedge ratio: theory and evidence

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  • Abdulnasser Hatemi-J
  • Youssef El-Khatib

Abstract

The minimum variance hedge ratio is widely used by investors to immunize against the price risk. This hedge ratio is usually assumed to be constant across time by practitioners, which might be a too restrictive assumption because the Optimal Hedge Ratio (OHR) might vary across time. In this article we put forward a proposition that a stochastic OHR performs differently than an OHR with constant structure even in the situations in which the mean value of the stochastic OHR is equal to the constant OHR. A mathematical proof is provided for this proposition combined with some simulation results and an application to the US stock market during 1999--2009 using weekly data.

Suggested Citation

  • Abdulnasser Hatemi-J & Youssef El-Khatib, 2012. "Stochastic optimal hedge ratio: theory and evidence," Applied Economics Letters, Taylor & Francis Journals, vol. 19(8), pages 699-703, May.
    • Handle: RePEc:taf:apeclt:v:19:y:2012:i:8:p:699-703
    DOI: 10.1080/13504851.2011.572841
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    References listed on IDEAS

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    1. Cecchetti, Stephen G & Cumby, Robert E & Figlewski, Stephen, 1988. "Estimation of the Optimal Futures Hedge," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 623-630, November.
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    3. Robert J. Myers & Stanley R. Thompson, 1989. "Generalized Optimal Hedge Ratio Estimation," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 71(4), pages 858-868.
    4. Kroner, Kenneth F. & Sultan, Jahangir, 1993. "Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(4), pages 535-551, December.
    5. Tae H. Park & Lorne N. Switzer, 1995. "Bivariate GARCH estimation of the optimal hedge ratios for stock index futures: A note," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 15(1), pages 61-67, February.
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    1. Ahmad Bash & Abdullah M. Al-Awadhi & Fouad Jamaani, 2016. "Measuring the Hedge Ratio: A GCC Perspective," International Journal of Economics and Finance, Canadian Center of Science and Education, vol. 8(7), pages 1-1, July.

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    More about this item

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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