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Hedging downside risk with futures contracts

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  • Donald Lien
  • Yiu Kuen Tse

Abstract

This paper considers a futures hedge strategy that minimizes the lower partial moments; such a strategy minimizes the downside risk and is consistent with the expected utility hypothesis. Two statistical methods are adopted to estimate the optimal hedge ratios: the empirical distribution function method and the kernel density estimation method. Both methods are applied to the Nikkei Stock Average (NSA) spot and futures markets. It is found that, for a hedger who is willing to absorb small losses but otherwise extremely cautious about large losses, the optimal hedge strategy that minimizes the lower partial moments may be sharply different from the minimum variance hedge strategy. If a hedger cares for downside-only risk, then the conventional minimum variance hedge strategy is inappropriate. The methods presented in this paper will be useful in these scenarios.

Suggested Citation

  • Donald Lien & Yiu Kuen Tse, 2000. "Hedging downside risk with futures contracts," Applied Financial Economics, Taylor & Francis Journals, vol. 10(2), pages 163-170.
  • Handle: RePEc:taf:apfiec:v:10:y:2000:i:2:p:163-170
    DOI: 10.1080/096031000331798
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    References listed on IDEAS

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    1. Korsvold, P.E., 1994. "Hedging Efficiency of Forward and Option Currency Contracts," Working Papers 195, University of Sydney, School of Economics.
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    1. Lien, Donald & Tse, Yiu Kuen, 2001. "Hedging downside risk: futures vs. options," International Review of Economics & Finance, Elsevier, vol. 10(2), pages 159-169.

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