Conditional volatility forecasting in a dynamic hedging model
Version of Record online: 1 APR 2005
Copyright © 2005 John Wiley & Sons, Ltd.
Journal of Forecasting
Volume 24, Issue 3, pages 155–172, April 2005
How to Cite
Haigh, M. S. (2005), Conditional volatility forecasting in a dynamic hedging model. J. Forecast., 24: 155–172. doi: 10.1002/for.950
- Issue online: 1 APR 2005
- Version of Record online: 1 APR 2005
- bid–ask spread;
- multi-period hedging;
- dynamic programming;
- forecasting volatility;
- multivariate GARCH
This paper addresses several questions surrounding volatility forecasting and its use in the estimation of optimal hedging ratios. Specifically: Are there economic gains by nesting time-series econometric models (GARCH) and dynamic programming models (therefore forecasting volatility several periods out) in the estimation of hedging ratios whilst accounting for volatility in the futures bid–ask spread? Are the forecasted hedging ratios (and wealth generated) from the nested bid–ask model statistically and economically different than standard approaches? Are there times when a trader following a basic model that does not forecast outperforms a trader using the nested bid–ask model? On all counts the results are encouraging—a trader that accounts for the bid–ask spread and forecasts volatility several periods in the nested model will incur lower transactions costs and gain significantly when the market suddenly and abruptly turns. Copyright © 2005 John Wiley & Sons, Ltd.