Determining the Optimal Dynamic Rebalancing Frequency for Delta-Neutral Hedges in Liffe Short-Term Interest-Rate Markets

Abstract

Evidence provided by market practitioners suggests that use of so-called "delta-neutral" hedging strategies is a common and effective approach. Delta-neutral (DN) strategies are derived from the well-known option pricing model of Black and Scholes (1973) or specifically here, the Black (1976) model for valuing interest-rate options on futures contracts. The general goal of a DN hedging approach is to make a combined option/futures portfolio immune to changes in the underlying asset (UA).

The principal objective of this research is to examine DN hedging effectiveness using differing portfolio rebalancing frequencies where the market-place considerations of both transaction costs (TCs) and returns/costs of margin requirements (MRs) are accounted for explicitly in the portfolio return calculations. In this context, the formulas developed for return calculations specifically incorporate the accounting recommendations suggested jointly in a publication by the London International Financial Futures and Options Exchange (LIFFE) and Price Waterhouse (1995).

This analysis considers hedging effectiveness (HE) along three dimensions, namely 1) traditional risk-minimization; 2) portfolio return maximization; and 3) the optimal risk-return tradeoff using the HBS measure developed and refined by Howard and D'Antonio (1987). Results are largely consistent across the Short Sterling, Euromark and Euroswiss markets and provide insight into the best hedging approach over the period analyzed in order to accomplish a specific objective. Firstly a comparison of returns inclusive of TCs/MRs to those where they are excluded evidences statistically significant differences using parametric tests. The implication is that analysis where these "market imperfections" are ignored may yield misleading results. The second and third major findings suggest, not surprisingly, that hedged portfolio returns (variances) are significantly higher (lower) when portfolio rebalancing occurs less (more) frequently. The final result is that when the Howard/D'Antonio HBS risk-return measure is used to assess the optimal hedging rebalancing strategy in the presence of TCs/MRs, the uniform conclusion is that a passive hedging approach yields the best risk-return tradeoff.

JEL Classification: G10, G11, G15