Can 'Time-Invariant' Hedges Estimated from Time-Varying Hedge Models Outperform Time-Invariant Hedges Even During Period of Financial Crisis? An Empirical Investigation of Indian Futures Market

Abstract

The real test of effectiveness of hedge models and its consistency happens when markets are turbulent and during extreme events. This study is, therefore, an attempt to explore Indian futures market for hedging by equity holders in general as well as in period of recent financial crisis. We have estimated effectiveness of the optimal hedge ratio based on HKM [Herbst, Kare and Marshall (1993)] methodology with benchmark model JSE [Johnson (1960), Stein (1961) and Ederington (1979)] methodology for futures. Hedge ratio based on HKM methodology is a time-variant whereas hedge ratio based on JSE methodology is a constant and time-invariant. To bring the comparison of hedge effectiveness on equal level (from transaction cost point of view), time-varying hedge ratio estimated based on HKM methodology are made “time-invariant” and then Bases using the hedge ratios are estimated.

For empirical validation of the Effectiveness of the optimal hedge ratios and their stability in normal as well in the period of financial crisis, the study of S&P Nifty Index {National Stock Exchange of India (NSE) – 50 Index and its futures is conducted using daily data for the year 2005 (representing normal period) and January, 2007 to June,2009 (representing turbulent time period) based on the value of volatility index.

Results suggest that hedge using HKM model is more effective than that of hedge based on JSE model. The results are statistically significant at 95% confidence level. An additional contribution of this study is to help the hedger to decide “when” to re-balance the hedge.

Keywords: hedging, market risk, capital market, futures market, regression, time- varying hedging models