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The Spider in the Hedge

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Author Info

  • Carol Alexander

    ()
    (ICMA Centre, University of Reading)

  • Andreza Barbosa

    ()
    (ICMA Centre, University of Reading)

Abstract

This paper provides an empirical study of the effectiveness of hedging the spider, a passive exchange traded fund (ETF) that replicates the S&P500 index. The spider is by far the largest ETF in the world: trading on the spider has grown so much during the past few years that it is now amongst the few most traded securities in the AMEX. The large net daily creation and redemption orders of recent years pose a problem to the market makers in the spider, as the orders may be too large to execute in the cash market. They face a decision about whether to hedge spider positions on their own book; and if so, how should they hedge? We have employed several sophisticated minimum variance estimates for the future hedge ratio, including OLS regression, an ECM to account for maturity effects and the cointegration of the spot and the future prices and, to the ECM residuals we apply EWMA and number of bivariate GARCH models to account for time-variation in the hedge ratio. We have applied these models to daily data for a 1-day rebalancing frequency and to weekly data for a 5-day re-balancing frequency, using data since the spider’s inception until the end of 2004. Marginal differences in the ‘optimal’ hedge ratios are apparent, but they are simply too small to have any significant effect on the hedged portfolio volatility. In out-of-sample testing we find that the naïve hedge where an equal and opposite position is taken in the future performs as well as the more technically sophisticated models, at both the daily and the weekly re-balancing frequency. Finally, we have considered the differences between hedging the spot index and hedging the spider. The efficiency of hedging the spider is superior to that of the index and the spider hedged portfolios have significantly lower volatility than the spot index hedged portfolios.

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Bibliographic Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2005-05.

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Length: 34 pages
Date of creation: Apr 2005
Date of revision:
Publication status: Published in Review of Futures Markets 2005, 11:1, 89-113
Handle: RePEc:rdg:icmadp:icma-dp2005-05

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Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA
Phone: +44 (0) 118 378 8226
Fax: +44 (0) 118 975 0236
Web page: http://www.henley.reading.ac.uk/
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References

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  1. Ackert, Lucy F. & Tian, Yisong S., 2001. "Efficiency in index options markets and trading in stock baskets," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1607-1634, September.
  2. Stephen G. Cecchetti & Robert E. Cumby & Stephen Figlewski, 1986. "Estimation of the optimal futures hedge," Research Working Paper 86-10, Federal Reserve Bank of Kansas City.
  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.
  4. Chris Brooks & Olan T. Henry & Gita Persand, 2002. "The Effect of Asymmetries on Optimal Hedge Ratios," The Journal of Business, University of Chicago Press, vol. 75(2), pages 333-352, April.
  5. 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.
  6. Lucy F. Ackert & Yisong S. Tian, 2000. "Arbitrage and Valuation in the Market forStandard and Poor's Depository Receipts," Financial Management, Financial Management Association, vol. 29(3), Fall.
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Citations

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Cited by:
  1. Cotter, John & Hanly, James, 2007. "Hedging Effectiveness under Conditions of Asymmetry," MPRA Paper 3501, University Library of Munich, Germany.
  2. Alexander, C. & Barbosa, A., 2008. "Hedging index exchange traded funds," Journal of Banking & Finance, Elsevier, vol. 32(2), pages 326-337, February.
  3. Carol Alexander & Andreza Barbosa, 2005. "Is Minimum Variance Hedging Necessary for Equity Indices? A study of Hedging and Cross-Hedging Exchange Traded Funds," ICMA Centre Discussion Papers in Finance icma-dp2005-16, Henley Business School, Reading University.

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