Using Regression Techniques to Estimate Futures Hedge Ratios, Some Results from Alternative Approaches Applied to Australian 10 Year Treasury Bond Futures

Edith Cowan Finance & Business Economics Working Paper

49 Pages Posted: 1 Oct 2001

See all articles by David E. Allen

David E. Allen

School of Mathematics and Statistics, The University of Sydney; Financial Research Network (FIRN); Department of Finance; School of Business and Law, Edith Cowan University

Garry MacDonald

Curtin University - School of Economics and Finance

Kathleen D. Walsh

University of New South Wales (UNSW) - Finance and Accounting

David M. Walsh

Sydney Office

Date Written: September 2001

Abstract

The paper uses Australian bond futures data from the Sydney Futures Exchange to critically assess some of the potential problems involved in the use of cointegration techniques in the calculation of minimum variance hedge ratios. Following Ghosh (1993a,b) there have been a number of papers which have made use of these techniques. Ghosh (1993), and Lien (1996) suggest that if spot and futures prices are cointegrated then the non-inclusion of an error correction term in the VAR model used to estimate the hedge ratio will lead to mis-specification problems and the under-estimation of the true optimal hedge ratio. We examine the use of such regression techniques in the calculation of hedge ratios.

In particular we consider the extent to which the stacking of the data into a time series, which effectively constrains the estimated hedge ratio to a single value over the span of the data, influences the results of such techniques. If the hedge ratio differs by contract, the movement from one contract to the next is likely to lead to instability in the estimated regression coefficients. Tests for parameter instability in the estimated regression suggest that this is indeed the case and our conclusion is that it is preferable to consider the estimation of the hedge ratio in a panel setting with each individual contract considered as an observational unit. One problem in the past with such a move has been the lack of tests for cointegration and unit roots in such a setting, fortunately these are now available and we take advantage of them in this paper. In such a panel setting we find that the result that the spot and futures prices are cointegrated still holds but that the estimated hedge ratios are not constant between contracts, throwing doubt on the applicability of regression methods which make such an assumption.

Keywords: Hedge ratios, cointegration, panel analysis

JEL Classification: G10, G13

Suggested Citation

Allen, David Edmund and MacDonald, Garry and Walsh, Kathleen (Kathy) D. and Walsh, David M., Using Regression Techniques to Estimate Futures Hedge Ratios, Some Results from Alternative Approaches Applied to Australian 10 Year Treasury Bond Futures (September 2001). Edith Cowan Finance & Business Economics Working Paper. Available at SSRN: https://ssrn.com/abstract=285210 or http://dx.doi.org/10.2139/ssrn.285210

David Edmund Allen (Contact Author)

School of Mathematics and Statistics, The University of Sydney ( email )

School of Mathematics and Statistics F07
University of Sydney
Sydney, New South Wales 2006
Australia

HOME PAGE: http://www.maths.usyd.edu.au

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Department of Finance ( email )

Taiwan
Taiwan

School of Business and Law, Edith Cowan University

100 Joondalup Drive
Joondalup, WA 6027
Australia

HOME PAGE: http://www.dallenwapty.com

Garry MacDonald

Curtin University - School of Economics and Finance ( email )

GPO Box U 1987
Perth, Western Australia 6845
Australia
+61 892267724 (Phone)

Kathleen (Kathy) D. Walsh

University of New South Wales (UNSW) - Finance and Accounting ( email )

Sydney, NSW 2052
Australia
9931 9531 (Phone)

David M. Walsh

Sydney Office

111 Harrington Street
Sydney NSW 2000
Australia
61 2 92722200 (Phone)

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