Hedging Capabilities Research Articles

The Comovement of Stock and Bond Returns

This paper finds that time variation in the covariance between stock and bond returns is the result of competition among several time-varying offsetting forces. The time variation in these offsetting forces can explain two quite different observations: (1) A very negative stock-bond covariance has been coupled with a very turbulent stock market over the last ten years, and (2) stock-bond covariance was around zero when stock market fluctuated dramatically after the two oil shocks in the 1970s. Different characteristics of inflation, and therefore different competition results among the offsetting forces, lead to such different behaviors of the stock-bond covariance during crisis periods. Government bonds are capable to hedge against stock market fluctuation, but their hedging capability can be weakened by high and uncertain inflation. If inflation is mild and stable, as it has been over the last 20 years, negative driving forces dominate positive driving forces during a turbulent period, leading to a negative stock-bond covariance. Thus the diversification power of government bonds increases as it is most needed. In addition, the findings in this paper provide empirical evidence and economic mechanisms to facilitate building theoretical models on explaining time-varying second moments of stock and bond returns.

Enhancing hedging performance with the spanning polynomial projection

Statistical time-series approaches to hedging are difficult to beat, especially out-of-sample, and are capable of out-performing many theory-based derivative pricing model approaches to hedging commodity price risks using futures contracts. However, the vast majority of time-series approaches to hedging discussed in the literature are essentially linear statistical projections, whether univariate or multivariate. Little is known about the potential hedging capabilities of nonlinear methods. This study describes how least-squares orthogonal polynomial approximation methods based on the spanning polynomial projection (SPP) can be used to enhance standard (linear) optimal hedging methods and improve hedging performance for a hedger with a mean–variance objective. Empirical analyses show that the SPP can be used effectively for hedging and gives better out-of-sample hedging performance than the benchmark VEC-GARCH hedging model. Results are robust to the inclusion of transaction costs and risk-aversion assumptions.

Option valuation based on the neural regression model

In this article, a neural regression (NR) model, which produces nonlinear coefficients of multiple regression model based on neural networks, is introduced to capture the option valuation's nonlinear characteristics effectively. The traditional linear regression uses the least-squares estimator to estimate the coefficient of a linear regression and thus may only produce suboptimal solutions. However, Applying neural networks to forecast volatility in option pricing has increased in popularity in recent years since many studies have indicated that the conventional option pricing models are not accurate enough. Our proposed neural regression model devotes to evaluate option values to improve on the tracking error in the measurement of hedging capability. The NR model uses the variables introduced by the Black-Scholes Model and applies the multiple regressions (MR) model to re-price option values. It is worth noting that each corresponding weight coefficient in MR is constructed by a complete neural network rather than by a scalar value. By capturing the nonlinear behaviors of option pricing, our proposed NR model has lower tracking error and better hedging capability than the BS model and other studies.

Private Commercial Real Estate Equity Returns and Inflation

The authors estimate, for total real estate and each of four property types, the extent to which various private commercial real estate returns, namely income, capital and total return, hedge against expected and unexpected inflation during the 1978-2006 period. Overall, total returns for all of the property types, except for retail, are shown to be a strong hedge against both expected and unexpected inflation. However, and interestingly, this hedging efficacy comes mostly from capital appreciation rather than income return. Thus the inflation hedging power of real estate seems to be more a product of the capital markets, rather than of the net income generating processes of real estate9s leasing and expense structures. In terms of inflation hedging capability, office is shown to be the strongest, followed by apartment and warehouse. Contrary to past studies and conventional wisdom, the retail sector is shown to have no significant hedging power against inflation. <b>TOPICS:</b>Real estate, risk management, statistical methods

Do Precious Metals Shine? An Investment Perspective

The investment role of precious metals in financial markets is investigated by analysis of daily data for gold, platinum, and silver from 1976 to 2004. All three precious metals have low correlations with stock index returns, which suggests that these metals may provide diversification within broad investment portfolios. Moreover, the data reveal that all three precious metals have some hedging capability, particularly during periods of "abnormal" stock market volatility. Financial portfolios that contain precious metals perform significantly better than standard equity portfolios.

Private Equity Returns: Is There Really a Benefit of Low Co-movement with Public Equity Markets?

In this paper we show how cross-sectional correlations between Private Equity (PE) and Public Market Equity (PM) returns can be approximated, resolving the lack of time series PE data. Based on a sample comprising 2,380 realized PE projects, we observe low crosssectional correlations between PE and stock index returns (e.g. 0.18 for Nasdaq Composite Index). Despite overall low correlations, we find that investor can not benefit from a diversification effect when they really need it - during times of low PM returns. We point out differences between early and later stage PE investments regarding hedging capabilities against bearish stock market conditions, triggered by distinct valuation approaches and exit channels. In contrast to early stage investors, later stage investors price projects based on fundamental information and are less dependent on IPOs as exit channel. We find significant statistical evidence for the negative correlation between early stage investments and excess returns over PM in bearish stock market conditions. Later stage investments exhibit a significant positive relation with excess returns over low PM returns. Investors seeking diversification benefits in PE should thus not solely rely on correlation coefficients, but need to carefully consider a fund’s investment strategy. The conflict of objectives for Venture funds between active market timing and smoothing of PM returns is resolved in favor of active market timing. Buyout funds’ returns are less dependent on PM developments and are thus the better complement for PM portfolios if investors seek diversification.

Climate Variables and Weather Derivatives: Gas Demand, Temperature and Seasonality Effects in the Italian Case

Weather derivatives are financial instrument that allow to hedge weather risk that is the financial gain or loss due to variability in climatic conditions. The market originated in 1998 when the US power community realised that the high volatility of revenues due to weather variability could be controlled and, since then, has grown rapidly both in terms of number of contracts concluded and notional value and in terms of variety of industry applications. The purpose of this study is to analyse the real hedging capabilities of weather derivatives on the Italian energy sector. This is achieved through the investigation of the existence of a robust statistically significant relation between energy, more specifically, gas consumption, and climate parameters. We investigate such a relation applying different models. The first is a simple regression where we estimate gas consumption, as the dependent variable, and temperature, rain, humidity and pressure as explicative variables. In the second model we introduce a derived temperature variable, the heating degree day function, in order to better capture the non linearity behaviour of gas consumption. In the third model we implement lagged, other than present, weather variables. In the fourth model we apply dummy variables in order to consider, daily, monthly and holiday patterns in gas consumption. In the fifth model, finally, we introduce an autoregressive structure in the error term. The paper is organised in five session. The first one summarises methodology and results of previous studies on this topic. Session three describes data. Session four presents methodology and results and session five reports our main conclusions.

The inflation‐hedging characteristics of UK property

Presents results of an investigation of the inflation‐hedging characteristics of UK property. Evaluates the various methods of decomposing inflation into its “expected” and “unexpected” components, using new time series data on inflation expectations produced by a questionnaire survey of informed market participants. Utilizes the power and suitability of causality and cointegration analysis to examine the relationship between inflation and property returns. Analyses the sensitivity of the results about the hedging capabilities of property to the removal valuation induced “smoothing” from property returns. Concludes that property is best seen as offering hedging characteristics that are only revealed in the long run.

Macroeconomic Sources of Time-Varying Risk Premia in the Term Structure of Interest Rates

ACCORDING TO INTERTEMPORAL CAPITAL ASSET pricing models (ICAPM) in finance (Merton 1983), risk premia are the prices of risk built in assets priced according to their hedging capabilities against the uncertainties related to the relevant state variables in the economy. As the uncertainties of the state variables change over time, the prices of the risk related to the state variables, and consequently the risk premia on assets in general, vary over time, too. Following the growing evidence of the failure of the expectations hypothesis and the existence of time-varying risk premia in the term structure [see Shiller (1990) for a survey on the literature], these equilibrium asset pricing models have received economists' attention as an attractive theoretical framework for modeling risk premia in the term structure of interest rates (for example, Breeden 1986; Campbell 1986, 1987). Several empirical studies attempted to test the validity of these equilibrium asset pricing models of the term structure. However, due to the failure of the theoretical ICAPM in finance to identify the important state variables, most of the studies employed empirical models that do not require a complete, explicit representation of the state variables. Consequently, those studies do not reveal any information about the importance of different macroeconomic forcing variables in the determination of time-varying risk premia. This paper investigates explicitly the linkage between time-varying risk premia in the term structure and macroeconomic state variables. In that respect, the study is

Currency swaps, hedging, and the exchange of collateral

A model of currency swaps is developed where swaps provide superior hedging capabilities. Under the swap two parties in effect ‘lease’ assets that they own to one another for use as collateral, creating supewrior loan-collateral matching. This superior matching is reflected in lower borrowing costs to both agents (creating a dominant borrowing and hedging method). The swap contract is self-enforcing due to a mutual double bonding arrangement, where each side has an interest in the continuation of the exchange relationship. (JEL G2, F3)

Portfolio insurance for foreign exchange risk management

Since the advent of floating exchange rates in the early 1970s management of exchange exposure has received much attention. Adler and Dumas [1, 21 and Dufey and Srinivasulu [14] contend that, because of imperfect markets for real goods and services and financial assets, exchange rate risk is relevant. Because of informational inefficiencies, exchange rate risk should be managed at the corporate rather than the shareholder level. Logue and Oldfield [22] and others suggest that hedging should be focused on cash flow rather than financial statement exposure. Several studies have evaluated and compared hedging alternatives that employ currency forward or futures contracts. Hill and Schneeweis 1191 compared the hedging capabilities of forward and futures contracts, finding no significant differences for the Deutschmark or British pound, but superior forward hedging for the Japanese yen. Babbel[5] used a mean-variance approach to compare the hedging effectiveness of the forward hedge and the money market hedge, Calderon-Rossel [12] provided a framework for choosing between either of these alternatives or not hedging. Swanson and Caples (291, Grammatikos [17], and others attempt to determine the optimal hedge ratio in currency futures and forward markets. Chang and Shanker [13] show that a synthetic futures contract generally exhibits less hedging effectiveness than currency futures contracts. And Eun and Resnick 1151, examining the hedging of interna~on~y diversified stock portfolios, report that substantial reductions in exchange rate risk obtain via forward contract hedging. While forward, futures, and ~ternational money market hedges effectively remove downside exchange risk, they also preclude the possibility of upside potential when exchange rates move in a favorable direction. An alternative