Abstract
ABSTRACT Hedging with financial futures is now more than ever an alternative for risk averted and risk neutral investors to help them manage their portfolio’s interest rate risk during volatile periods and periods of active monetary policy. Managing changing volatility is an issue that has fostered the need for traditional mean variance and more sophisticated estimation and prediction models applied to financial market instrument analysis. The purpose of this paper is to measure the degree of predictive capability of selected financial futures instruments to forecast the underlined cash market (spot) instruments in order to assess how well the instruments serve to establish a hedging strategy.The research focuses in the application of time series methodologies and models to simulate situations that investors face regarding interest rate volatility, which affect their portfolio values. In this study, tests of market efficiency in the convergence of futures market instruments to their underlined spot markets counterparts are performed in order to verify how well the futures market can predict the cash market and measure bias risk and persistence (long term memory). Our testing of hedging effectiveness or optimal hedging capability will be assessed using the traditional financial Unbiased Forward Rate Hypothesis (UFRH). Market efficiency tests show that the UFRH holds for 7 out of 14 instrument co-integrated combinations using futures market hedges. Futures market’s relative efficiency is explained with the statistically significant convergence of the futures Treasury Bills, Fed Funds and Eurodollars instruments to the spot market at expiration dates for terms shorter than six month, using weekly data series analysis for periods between 1991 through 2011. Keywords Market Efficiency, UFRH; Convergence; Co-integration; Error Correction Model; E-Garch; Risk Premium; Noise Risk; Forward Risk; Behavioral Anomalies; Order Flow Information.
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