Effectiveness of Time-Varying Hedge Ratio with Constant Conditional Correlation: Empirical Evidence from U.S. Treasury Market

Abstract

This study demonstrates how hedging methodologies can be evaluated in a modern risk management context and provides a hedging effectiveness of dynamic hedge ratios. The results provide an indication of the superior performance of the time varying hedge ratio as compared with traditional constant ratio. Time varying hedge ratio estimated by CCC-GARCH model shows a clear advantage over linear regression based constant hedge ratio in minimizing the variance (risk) of portfolio returns over the whole 10 years of analysis. The time-varying hedge ratio estimated in our study provides an efficient measure for bond investors to maximize the value of their investments by changing positions in both spot and future markets of U.S. Treasuries with the change in actual yields of cash market. The results are robust in the sense that constant conditional correlation model does take account of the conditional heteroskedasticity present in the data in case of spot market.