Hedge Ratio and Correlation between the Stock and the Futures Markets: Evidence from the Wavelet Analysis

Abstract:     
This paper examines the relationship between the stock and the futures return over the various time horizons. In contrast to previous studies, wavelet analysis allows us to decompose the data into various time scales. Using this technique, we find that in the short- and long-run, there is a feedback relationship, while in the intermediate-run, the futures market leads the stock market. The correlation between the two markets varies over time but remains very high. Furthermore, the magnitude of the correlation increases as the time scale increases, indicating that the stock market and the futures market of the All Ordinaries Index are found to be not fundamentally different. The hedge ratio increases as the time scale increases. In other words, the effectiveness of the hedging strategies initially increases with the hedging horizon.

Working Paper Series