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Keywords:

  • Hedge ratio;
  • Cointegration;
  • GARCH
  • G15;
  • C51;
  • C52

Abstract

We use the All Ordinaries Index and the corresponding Share Price Index futures contract written against the All Ordinaries Index to estimate optimal hedge ratios, adopting several specifications: an ordinary least squares-based model, a vector autoregression, a vector error-correction model and a diagonal-vec multivariate generalized autoregressive conditional heteroscedasticity model. Hedging effectiveness is measured using a risk-return comparison and a utility maximization method. We find that time-varying generalized autoregressive conditional heteroscedasticity hedge ratios perform better than constant hedge ratios in terms of minimizing risks, but when return effects are also considered, the utility-based measure prefers the ordinary least squares method in the in-sample hedge, whilst both approaches favour the conditional time-varying multivariate generalized autoregressive conditional heteroscedasticity hedge ratio estimates in out-of-sample analyses.