Research Article

Optimal Hedge Ratio Estimation and Effectiveness Using ARCD†

  1. Eleftheria Kostika1,
  2. Raphael N. Markellos2,*

Article first published online: 23 JAN 2012

DOI: 10.1002/for.1249

Additional Information

How to Cite

Kostika, E. and Markellos, R. N. (2012), Optimal Hedge Ratio Estimation and Effectiveness Using ARCD. J. Forecast.. doi: 10.1002/for.1249

Author Information

  1. 1

    Bank of Greece, Athens; and Department of Management Science and Technology, Athens University of Economics and Business, Greece

  2. 2

    Department of Management Science and Technology, Athens University of Economics and Business, Greece; and Centre for International Financial and Economic Research, Loughborough University, UK

* Raphael N. Markellos, Department of Management Science and Technology, Athens University of Economics and Business, Office 915, 47A Evelpidon St, 113 62 Athens, Greece. E-mail: rmarkel@aueb.gr

  1. †

    All views expressed belong to the authors and do not necessarily reflect the views of the Bank of Greece.

Publication History

  1. Article first published online: 23 JAN 2012
  2. Manuscript Accepted: 25 JUL 2011
  3. Manuscript Received: 28 JAN 2011

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Keywords:

  • optimal hedge ratios;
  • dynamic futures hedging;
  • ARCD;
  • higher moments

ABSTRACT

This paper examines the importance of forecasting higher moments for optimal hedge ratio estimation. To this end, autoregressive conditional density (ARCD) models are employed which allow for time variation in variance, skewness and kurtosis. The performance of ARCD models is evaluated against that of GARCH and of other conventional hedge ratio estimation methodologies based on exponentially weighted moving averages, ordinary least squares and error correction, respectively. An empirical application using spot and futures data on the DJI, FTSE and DAX equity indices compares the in-sample and out-of-sample hedging effectiveness of each approach in terms of risk minimization. The results show that the ARCD approach has the best performance, thus suggesting that forecasting higher moments is of practical importance for futures hedging. Copyright © 2012 John Wiley & Sons, Ltd.

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