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

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Author Info
Michael T. Chng () (University of Melbourne)
Gerard L. Gannon () (Deakin University)
Abstract

In this paper, 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, ESVLbased 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 .

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File URL: http://www.deakin.edu.au/buslaw/aef/workingpapers/papers/2008_01aef.pdf
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Publisher Info
Paper provided by Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance in its series Accounting, Finance, Financial Planning and Insurance Series with number 2008_01.

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Length: 40 pages
Date of creation: 06 May 2008
Date of revision:
Handle: RePEc:dkn:acctwp:aef_2008_01

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Related research
Keywords: volatility transmission; dynamic hedging; optimal hedge ratio; S&P 500;

Find related papers by JEL classification:
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

References listed on IDEAS
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  1. Baillie, Richard T & Myers, Robert J, 1991. "Bivariate GARCH Estimation of the Optimal Commodity Futures Hedge," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 6(2), pages 109-24, April-Jun. [Downloadable!] (restricted)
  2. Yeh, Sally C & Gannon, Gerard L, 2000. " Comparing Trading Performance of the Constant and Dynamic Hedge Models: A Note," Review of Quantitative Finance and Accounting, Springer, vol. 14(2), pages 155-60, March. [Downloadable!] (restricted)
  3. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March. [Downloadable!] (restricted)
  4. Tse, Y K & Tsui, Albert K C, 2002. "A Multivariate Generalized Autoregressive Conditional Heteroscedasticity Model with Time-Varying Correlations," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 351-62, July.
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