The Limits to Minimum-Variance Hedging

University of Exeter XFi Working Paper No. 07-12

34 Pages Posted: 5 Nov 2007

See all articles by Richard D. F. Harris

Richard D. F. Harris

University of Bristol, School of Accounting and Finance; University of Bristol, School of Accounting and Finance

Jian Shen

University of Exeter Business School

Evarist Stoja

University of Bristol

Date Written: October 2007

Abstract

Models of the time-varying conditional minimum-variance hedge ratio (MVHR) typically do not provide a significant improvement in terms of hedging performance over the unconditional MVHR model. In view of the widely documented success of conditional volatility models (on which models of the conditional MVHR are usually based), this is somewhat surprising. In this paper, using the recently developed realized beta framework of Andersen, Bollerslev, Diebold and Wu (2005), we explore the reasons for this finding. We firstly show that the reduction in hedged portfolio variance that conditional MVHR models offer falls far short of the ex post maximal reduction in variance obtained using an estimate of the unobserved 'integrated' MVHR. We investigate the statistical properties of the forecasts of conditional MVHR models and show that while they do contain significant information about the integrated MVHR, they are systematically biased and inefficient. However, correcting for this bias and inefficiency does little to improve their hedging performance, suggesting that their poor performance is more likely to be attributable to the unpredictability of the integrated MVHR.

Keywords: Minimum-variance hedge ratio, Realized beta, Multivariate conditional volatility models, Bias correction

JEL Classification: G10

Suggested Citation

Harris, Richard D. F. and Shen, Jian and Stoja, Evarist, The Limits to Minimum-Variance Hedging (October 2007). University of Exeter XFi Working Paper No. 07-12, Available at SSRN: https://ssrn.com/abstract=1027613 or http://dx.doi.org/10.2139/ssrn.1027613

University of Bristol, School of Accounting and Finance

United Kingdom

HOME PAGE: http://www.bristol.ac.uk/people/person/Richard-Harris-50ffa5fb-0e86-4458-8e8c-8dace6eb3435/

Jian Shen

University of Exeter Business School ( email )

Streatham Court
Xfi Building, Rennes Dr.
Exeter, EX4 4JH
United Kingdom

Evarist Stoja

University of Bristol ( email )

School of Accounting and Finance
8 Woodland Road
Bristol, BS8 1TN
United Kingdom

HOME PAGE: http://sites.google.com/view/evarist-stoja/

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