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Minimum‐variance futures hedging under alternative return specifications

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  • Eric Terry

Abstract

It is widely believed that the conventional futures hedge ratio, is variance‐minimizing when it is computed using percentage returns or log returns. It is shown that the conventional hedge ratio is variance‐minimizing when computed from returns measured in dollar terms but not from returns measured in percentage or log terms. Formulas for the minimum‐variance hedge ratio under percentage and log returns are derived. The difference between the conventional hedge ratio computed from percentage and log returns and the minimum‐variance hedge ratio is found to be relatively small when directly hedging, especially when using near‐maturity futures. However, the minimum‐variance hedge ratio can vary significantly from the conventional hedge ratio computed from percentage or log returns when used in cross‐hedging situations. Simulation analysis shows that the incorrect application of the conventional hedge ratio in crosshedging situations can substantially reduce hedging performance. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:537–552, 2005

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  • Eric Terry, 2005. "Minimum‐variance futures hedging under alternative return specifications," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 25(6), pages 537-552, June.
    • Handle: RePEc:wly:jfutmk:v:25:y:2005:i:6:p:537-552
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    Cited by:

    1. Donald Lien & Ziling Wang & Xiaojian Yu, 2021. "Optimal quantile hedging under Markov regime switching," Empirical Economics, Springer, vol. 60(5), pages 2177-2201, May.
    2. Wan-Yi Chiu, 2020. "The global minimum variance hedge," Review of Derivatives Research, Springer, vol. 23(2), pages 121-144, July.

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