Hedging effectiveness of stock index futures

Abstract

The paper is concerned with the efficiency of hedging stock portfolios using futures stock indices covering the period January 1995–December 2001. The hedged portfolios consisted of the assets of seventeen investment companies quoted on the London Stock Exchange and two portfolios, which were assumed to match exactly the corresponding cash index. Two futures indices were used to hedge the funds namely FTSE100 and FTSE250 futures indices which are quoted on LIFFE. Weekly observations were used providing 365 observations for each variable. The total sample was split into two sections. The first 261 observations were used to estimate the optimal hedge ratio (i.e. the in-sample period) providing 260 returns for each variable and the remaining 104 (i.e. the post-sample period) observations utilised to check the efficiency of the estimated hedge ratio. In addition a second estimation window was tried using the last 30 observations of the in-sample period. A variety of methods were tried to estimate the optimal hedge ratio including ordinary least squares (OLS), methods allowing for the existence of Autoregressive Conditional Heteroskedasticity, and an Exponential Weighted Moving Average (EWMA). The general conclusions reached were that for the portfolios within the data set (i) that the EWMA method of estimation provided the best estimate of the optimal hedge (ii) the shorter estimation window was no more efficient than the longer window and (ii) the FTESE250 futures index was the best hedging vehicle for these portfolios.