Combining Time-Varying And Dynamic Multi-Period Optimal Hedging Models
This paper presents an effective way of combining two popular, yet distinct approaches used in the hedging literature dynamic programming (DP) and time-series (GARCH) econometrics. Theoretically consistent yet realistic and tractable models are developed for traders interested in hedging a portfolio. Results from a bootstrapping experiment used to construct confidence bands around the competing portfolios suggest that while DP-GARCH outperforms the GARCH approach they are statistically equivalent to the OLS approach when the markets are stable. Significant gains may be achieved by a trader, however, by adopting the DPGARCH model over the OLS approach when markets exhibit excessive volatility.
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