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Sudden changes in variance and time varying hedge ratios

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  • Aragó, Vicent
  • Salvador, Enrique

Abstract

This paper analyzes the influence of sudden changes in the unconditional volatility on the estimation and forecast of volatility and its impact on futures hedging strategies. We employ several multivariate GARCH models to estimate the optimal hedge ratios for the Spanish stock market including in each one some well-known patterns that may affect volatility forecasts (asymmetry and sudden changes). The main empirical results show that more complex models including sudden changes in volatility outperform the simpler models in hedging effectiveness both with in-sample and out-of-sample analysis. However, the evidence is stronger when the loss distribution tail is used as a measure for the effectiveness (Value at Risk (VaR) and Expected Shortfall (ES)) suggesting that traditional measures based on the variance of the hedged portfolio should be used with caution.

Suggested Citation

  • Aragó, Vicent & Salvador, Enrique, 2011. "Sudden changes in variance and time varying hedge ratios," European Journal of Operational Research, Elsevier, vol. 215(2), pages 393-403, December.
    • Handle: RePEc:eee:ejores:v:215:y:2011:i:2:p:393-403
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    9. Sinem Derindere KOSEOGLU & Emrah Ismail CEVIK, 2013. "Testing for Causality in Mean and Variance between the Stock Market and the Foreign Exchange Market: An Application to the Major Central and Eastern European Countries," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 63(1), pages 65-86, March.
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