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Abstract

The paper presents a new methodology to estimate time dependent minimum variance hedge ratios. The so-called conditional OLS hedge ratio modifies the static OLS approach to incorporate conditioning information. The ability of the conditional OLS hedge ratio to minimize the risk of a hedged portfolio is compared to conventional static and dynamic approaches, such as the naïve hedge, the roll-over OLS hedge, and the bivariate GARCH(1,1) model. The paper concludes that, both in-sample and out-of-sample, the conditional OLS hedge ratio reduces the basis risk of an equity portfolio better than the alternatives conventionally used in risk management. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:945–964, 2004