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The Trading Performance of Dynamic Hedging Models: Time Varying Covariance and Volatility Transmission Effects

In: Encyclopedia of Finance

Author

Listed:
  • Michael T. Chng

    (Deakin University)

  • Gerard L. Gannon

    (Deakin University)

Abstract

In this chapter, we investigate the value of incorporating implied volatility from related option markets in dynamic hedging. We comprehensively model the volatility of all four S&P 500 cash, futures, index option and futures option markets simultaneously. Synchronous half-hourly observations are sampled from transaction data. Special classes of extended simultaneous volatility systems (ESVL) are estimated and used to generate out-of-sample hedge ratios. In a hypothetical dynamic hedging scheme, ESVL-based hedge ratios, which incorporate incremental information in the implied volatilities of the two S&P 500 option markets, generate profits from interim rebalancing of the futures hedging position that are incremental over competing hedge ratios. In addition, ESVL-based hedge ratios are the only hedge ratios that manage to generate sufficient profit during the hedging period to cover losses incurred by the physical portfolio.

Suggested Citation

  • Michael T. Chng & Gerard L. Gannon, 2022. "The Trading Performance of Dynamic Hedging Models: Time Varying Covariance and Volatility Transmission Effects," Springer Books, in: Cheng-Few Lee & Alice C. Lee (ed.), Encyclopedia of Finance, edition 0, chapter 61, pages 1411-1435, Springer.
    • Handle: RePEc:spr:sprchp:978-3-030-91231-4_61
    DOI: 10.1007/978-3-030-91231-4_61
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    More about this item

    Keywords

    Volatility transmission; Dynamic hedging; Optimal hedge ratio; S&P 500;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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