Stability And Effectiveness Of Hedge Ratios In Volatile Index Futures Markets: Hong Kong and Korean Markets

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ACKNOWLEDGEMENT

I would take this opportunity to thank my research supervisor, family and friends for their support and guidance without which this research would not have been possible

DECLARATION

I, [type your full first names and surname here], declare that the contents of this dissertation/thesis represent my own unaided work, and that the dissertation/thesis has not previously been submitted for academic examination towards any qualification. Furthermore, it represents my own opinions and not necessarily those of the University (Bardhan, 2001, 467).

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Abstract

This paper investigates the hedging performance of both the HSIF and HHIF contracts using daily data for the period January 2007-June 2008. The hedged portfolios consist of market indices and unit funds. The dynamic OLS-modeled strategies and EWMA-modeled hedging strategies for both 63-day and 126-day estimation windows are compared. The results show that (1) compared to the HSIF contract, the HHIF contract is an important additional hedging instrument; (2) the EWMA model is slightly superior to the dynamic OLS model generally; (3) the cross-hedging effectiveness for actual spot portfolios to be hedged appears to be much lower than that for market indices.

When using derivative instruments such as futures in order to hedge a portfolio of risky assets, the primary objective is to estimate the optimal hedge ratio (OHR). When agents have mean-variance utility and the futures price follows a martingale, the OHR is equivalent to the minimum variance hedge ratio, which can be estimated by regressing the spot market return on the futures market return using ordinary least squares. In order to accommodate time varying volatility in asset returns, estimators based on rolling windows, GARCH or EWMA models are commonly employed. However, all of these approaches are based on the sample variance and covariance estimators of returns, which while consistent irrespective of the underlying distribution of the data, are not in general efficient. In particular, when the distribution of the data is leptokurtic, as is commonly found for short horizon asset returns, these estimators will attach too much weight to extreme observations. This paper proposes an alternative to the standard approach to the estimation of the OHR that is robust to the leptokurtosis of returns. We use the robust OHR to construct a dynamic hedging strategy for daily returns on the KOSPI INDEX using index futures. We estimate the robust OHR using both the rolling window approach and the EWMA approach, and compare our results to those based on the standard rolling window and EWMA estimators. It is shown that the robust OHR yields a hedged portfolio variance that is marginally lower than that based on the standard estimator. Moreover, the variance of the robust OHR is as much as 70% lower than the variance of the standard OHR, substantially reducing the transaction costs that are associated with dynamic hedging strategies.

TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION1

1.1 Background of the study1

1.2 Problem Statement3

1.3 Significance of the Study5

1.4 Purpose of the study6

CHAPTER 2: LITERATURE ...