Futures Hedging when the Composition of the Underlying Asset Changes; The Case of the BIFFEX Contract

Abstract

This article is concerned with the hedging effectiveness of futures contracts whose underlying asset is an index, when the structure of this index is changing. The case of the freight futures (BIFFEX) contract is examined here. Investigation of this issue is particularly interesting as the composition of its underlying asset, the Baltic Freight Index (BFI), has been revised on a number of occasions in order to improve the hedging performance of the market; previous empirical evidence on the market indicates substantially lower variance reduction (4-19%), compared to other markets (up to 98%). The BFI is a weighted average dry-cargo freight rate index, compiled from actual freight rates on 11 shipping routes that are dissimilar in terms of vessel sizes and transported commodities. The hedging effectiveness of the market is investigated using both constant and time-varying hedge ratios, estimated through bivariate error correction GARCH models. Our results indicate that the effectiveness of the BIFFEX contract as a centre For risk management has strengthened over the recent years as a result of tbe more homogeneous composition of the index. This by itself indicates that the latest restructuring of the index, in November 1999, which is aimed at increasing its homogeneity even further, is likely to bave a beneficial impact on tbe market.