Swap variance hedging and efficiency: The role of high moments

Abstract

AbstractIn this article, we propose a new theoretical approach for developing hedging strategies based on swap variance (SwV). SwV is a generalized risk measure equivalent to a polynomial combination of all moments of a return distribution. Using the S&P 500 index and West Texas Intermediate (WTI) crude oil spot and futures price data, as well as simulations by varying the distribution of asset returns, we investigate the dynamic differences between hedge ratios and portfolio performances based on SwV (with high moments) and variance (without high moments). We find that, on average, the minimizing‐SwV hedging suggests more short futures contracts than minimizing‐variance hedging; however, when market conditions deteriorate, the minimizing‐SwV hedging suggests fewer short positions in futures. The superior posthedge performances of the mean‐SwV hedged portfolios over the mean‐variance hedged portfolios in highly volatile or extremely calm markets confirm the efficiency of the mean‐SwV hedging strategy.