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

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  • Michael T. Chng
  • Gerard L. Gannon

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 .

Suggested Citation

  • Michael T. Chng & Gerard L. Gannon, 2009. "The Trading Performance of Dynamic Hedging Models: Time Varying Covariance and Volatility Transmission Effects," Working Papers 2009_02, Deakin University, Department of Economics.
    • Handle: RePEc:dkn:acctwp:aef_2009_02
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    File URL: http://www.deakin.edu.au/buslaw/aef/workingpapers/papers/2009_02aef.pdf
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    More about this item

    Keywords

    volatility transmission; dynamic hedging; optimal hedge ratio; S&P 500;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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