Structurally sound dynamic index futures hedging

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Abstract

Portfolio managers use index futures for a variety of reasons. Regardless of their motivation, they will keep a close eye on the relation between the index futures returns and their stock-portfolio returns. Whenever this relation is perceived to have changed, the manager will decide whether it is worthwhile to rebalance the index futures—portfolio mix accordingly. Exact measures as to when and how much rebalancing should occur have not yet been established. This article proposes a dynamic hedging algorithm based on a reverse order CUSUM-squared (ROC) testing procedure, first discussed in M. H. Pesaran and A. Timmermann (2002). A comparison with standard alternatives (naïve, expanding, EWLS, and rolling estimation windows) finds limited improvements in hedging performance, both in- and out-of-sample. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:1173–1202, 2005

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