Abstract
This article investigates the effectiveness of TAIEX (Taiwan Stock Exchange) futures, Taiwan 50 futures, and nonfinance nonelectronics subindex (NFNE) futures for cross hedging the price risk of stock sector indices traded on the Taiwan stock exchange. A state-dependent volatility spillover GARCH hedging strategy is developed to capture the regime switching global equity volatility spillover effect. Empirical results show that the NFNE futures exhibit superior effectiveness as an instrument for hedging stock sector exposures compared with the TAIEX and Taiwan 50 futures. Simultaneous hedge using both NFNE and MSCI (Morgan Stanley Capital International) world index futures further improves the hedging effectiveness compared with the hedging strategy using only the NFNE futures. This shows the importance of hedging the global equity systematic risk of stock sectors by considering the comovement between domestic and global equity markets.
Highlights
It is well documented that the joint distribution of spot and futures returns is time varying
We find that the nonfinance nonelectronics subindex (NFNE) futures perform better than the Taiwan 50 and TAIEX futures
Because there are no corresponding sector futures for most sector indices traded on the Taiwan stock exchange, closely related futures must be applied for cross hedging the spot exposures on stock sectors
Summary
It is well documented that the joint distribution of spot and futures returns is time varying. We consider simultaneous hedging using both NFNE and MSCI (Morgan Stanley Capital International) world index futures to hedge the domestic and global equity systematic risks of stock sectors with a regime switching volatility spillover GARCH (RSVSG) model. This paper envisions a regime switching volatility spillover GARCH (RSVSG) model to hedge the price risk of stock sector holdings with both domestic and global stock index futures. Where εW,t,st is the normalized state-dependent global stock shock and hW,t is the volatility of world stock index futures returns assumed to follow a regime switching GARCH(1,1) process: hW,t,st = γW,st + αW,st eW2 ,t−1,st + βW hW,t−1,st. Φst and ωst are state-dependent volatility spillover parameters for the stock sector index and domestic stock index futures, respectively. The state-dependent volatility spillover ratios for domestic stock sector index and domestic stock index futures are respectively given by.
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