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The optimal value-at-risk hedging strategy under bivariate regime switching ARCH framework

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  • Kuang-Liang Chang

Abstract

Unlike the majority of other hedging literatures in which variance is taken as the risk indicator, this article uses the Value-at-Risk (VaR) as the risk management tool of the hedged portfolio. This article adopts a bivariate Markov regime Switching Autoregressive Conditional Heteroscedastic (SWARCH) model to formulate the optimal VaR hedging strategy and then compares it with the other dynamic futures hedging strategies mentioned in the literature in hedging performance. Using Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) futures data, the in-sample and out-of-sample results shows that when VaR is used as the criterion to measure the futures hedging effectiveness, the performance of the dynamic hedging strategy is superior to that of the static hedging strategy, and the performance of the optimal VaR hedging strategy is better than that of the minimum variance and mean-variance hedging strategies. Besides, from the standpoint that the volatility of hedge ratio and hedged portfolio variance decline, no matter what kind of hedging strategy is adopted, the regime switching model is better in in-sample and out-of-sample hedging effectiveness than the Generalized Autoregressive Conditional Heteroscedastic (GARCH) model.

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  • Kuang-Liang Chang, 2011. "The optimal value-at-risk hedging strategy under bivariate regime switching ARCH framework," Applied Economics, Taylor & Francis Journals, vol. 43(21), pages 2627-2640.
  • Handle: RePEc:taf:applec:v:43:y:2011:i:21:p:2627-2640
    DOI: 10.1080/00036840903299771
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