Criteria for Determining the Appropriateness of Time-Varying Hedge Ratios.
by
Riccardo Biondini
Department of Accounting and Finance, University of Wollongong, Australia
Coauthors: Yan-Xia Lin, School of Mathematics and Applied Statistics, University of Wollongong, Australia, Michael McCrae, Department of Accounting and Finance, University of Wollongong, Australia

In traditional finance theory there is the implicit assumption that the risk in spot and futures markets is constant over time, thus ignoring the possible dynamic (time-varying) nature of the distribution of the asset returns. This in turn implies that the minimum risk hedge ratio will be the same irrespective of when the hedge is undertaken. This article examines the criteria under which time-varying hedge ratios are optimal from the perspective of a bona-fide hedger, assuming the spot and futures returns exhibit time-varying variance. Under such a scenario the resultant hedge ratio is unstable and should be regularly updated. The ability of time-varying approaches to minimise risk is compared to the conventional static procedures of naive and minimum variance hedging. It is shown that if the hedge ratio is unstable then allowance for such stochastic movements will increase hedging effectiveness by reducing the volatility of the hedged portfolio. Finally, a hedging rule is determined which enables a comparison of two constant hedge ratios which bypasses the need for transaction cost consideration.

Date received: November 14, 2001