Sudden Changes in Variance and Time Varying Hedge Ratios

Posted: 26 Mar 2011  

Enrique Salvador

Universitat Jaume I

Vicent Aragó

Jaume I University

Date Written: March 24, 2011

Abstract

This paper analyzes the influence of sudden changes in the unconditional volatility on the estimation and forecast of volatility and its impact on futures hedging strategies. We employ several multivariate GARCH models to estimate the optimal hedge ratios for the Spanish stock market including in each one some well-known patterns that may affect volatility forecasts (asymmetry and sudden changes). The main empirical results show that more complex models including sudden changes in volatility outperform the simpler models in hedging effectiveness both with in-sample and out-of-sample analysis. However, the evidence is stronger when the tail loss distribution is used as a measure for the effectiveness Value at Risk (VaR) and Expected Shortfall (ES) suggesting that traditional measures based on the variance of the hedge portfolio should be used with caution.

Keywords: Finance, Hedging effectiveness, GARCH, sudden changes in variance

Suggested Citation

Salvador, Enrique and Aragó, Vicent, Sudden Changes in Variance and Time Varying Hedge Ratios (March 24, 2011). Available at SSRN: https://ssrn.com/abstract=1794164 or http://dx.doi.org/10.2139/ssrn.1794164

Enrique Salvador (Contact Author)

Universitat Jaume I ( email )

Castellon
E-12071 Castello de la Plana
Spain

Vicent Aragó

Jaume I University ( email )

Avda Sos Baynat s/N
Castellón, 12071
Spain

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