Determination of Optimal Hedging Strategy for Index Futures: Evidence from Turkey

This paper aims to determine optimal hedge strategy for the Istanbul Stock Exchange (ISE)-30 stock index futures in Turkey by comparing hedging performance of constant and time-varying hedge ratios under mean-variance utility criteria. We employ standard regression and bivariate GARCH frameworks to estimate constant and time-varying hedge ratios respectively. The Turkish case is particularly challenging since Turkey has one of the most volatile stock markets among emerging economies and the turnover ratio as a measure of liquidity is very high for the market. These facts can be considered to highlight the great risk and, therefore, the extra need for hedging in the Istanbul Stock Exchange (ISE). The empirical results from the study reveal that the dynamic hedge strategy outperforms the static and the traditional strategies.     

盯市风险下的期货套期保值

本文把盯市风险引入传统的期货套期保值框架，论证了在考虑盯市风险的情况下，一个关注每日最大亏损值的套期保值者会显著地减少他的期货头寸。在一个中期的套期保值期内，该套期保值者的期货套期保值头寸约为其现货头寸的80％。盯市风险的影响随着套期保值期的延长而缓慢减弱。如果套期保值者关注的是每日平均亏损值，在一个中期的套期保值期内盯市风险的影响极小。     

An International Asset Pricing Model with Time-Varying Hedging Risk

This paper employs a two-factor international equilibrium asset pricing model to examine the pricing relationships among the world's five largest equity markets. In addition to the traditional market factor premium, a hedging factor premium is included as the second factor to explain the relationship between risks and returns in the international stock markets. Moreover, a GARCH parameterization is adopted to characterize the general dynamics of the conditional second moments. The results suggest that the additional hedging risk premium is needed to explain rates of return on international equities. Furthermore, the restriction that the coefficient on the hedge-portfolio covariance is one smaller than the coefficient on the market-portfolio covariance can not be rejected. This suggests that the intertemporal asset pricing model proposed by Campbell (1993) can be used to explain the returns on the five largest stock market indices.     

Hedging errors with Leland's option model in the presence of transaction costs

Nonzero transaction costs invalidate the Black–Scholes [1973. Journal of Political Economy 81, 637–654] arbitrage argument based on continuous trading. Leland [1985. Journal of Finance 40, 1283–1301] developed a hedging strategy which modifies the Black–Scholes hedging strategy with a volatility adjusted by the length of the rebalance interval and the rate of the proportional transaction cost. Kabanov and Safarian [1997. Finance and Stochastics 1, 239–250] calculated the limiting hedging error of the Leland strategy and pointed out that it is nonzero for the approximate pricing of an European call option, in contradiction to Leland's claim. As a further contribution, we first identify the mathematical flaw in the argument of Leland's claim and then quantify the expected percentage of hedging losses in terms of the hedging frequency and the level of the option strike price.     

Hedging with Chinese Aluminum Futures: International Evidence with Return and Volatility Spillover Indices Under Structural Breaks

This paper examines the hedging performance of the Shanghai futures market, with the London futures market acting as the channel for volatility spillover. Taking into consideration structural change, basis effects, and return and volatility spillover effects, the authors find that the estimated hedging performance is not improved. Their findings suggest that the effectiveness of the hedging performance of aluminum futures contracts in China is not affected by the magnitude or direction of return and volatility spillovers. Therefore, even when the magnitude and direction of volatility spillover from other markets can be correctly predicted, the hedging performance of a futures contract cannot be significantly improved. This paper uses precise measures of return spillovers and volatility spillovers based directly on the framework of vector autoregressive variance decompositions. The study also includes an analysis of both crisis and noncrisis episodes, with modeling on bursts in spillovers.     

The Inflation Hedging Characteristics of US and UK Investments: A Multi-Factor Error Correction Approach

Historic analysis of the inflation hedging properties of stocks has produced anomalous results, with stocks often appearing to offer a perverse hedge. This has been attributed to the impact of real and monetary shocks to the economy, which influence both inflation and asset returns. It has been argued that real estate should provide a better hedge: however, empirical results have been mixed. This paper explores the relationship between commercial real estate returns and economic, fiscal and monetary factors and inflation for US and UK markets. Comparative analysis of general equity and small capitalization stock returns is carried out with inflation divided into expected and unexpected components. The analyses are undertaken using an error correction approach. In the long run, once real and monetary variables are included, asset returns are positively linked to anticipated inflation but not to inflation shocks. Adjustment processes are, however, gradual and not within period. Real estate returns, particularly private market returns, exhibit characteristics that differ from those of stocks.

Ex Ante Hedging Effectiveness of UK Stock Index Futures Contracts: Evidence for the FTSE 100 and FTSE Mid 250 Contracts

Ex ante hedging effectiveness of the FTSE 100 and FTSE Mid 250 index futures contracts is examined for a range of portfolios, consisting of stock market indexes and professionally managed portfolios (investment trust companies). Previous studies which focused on ex post hedging performance using spot portfolios that mirror market indexes are shown to overstate the risk reduction potential of index futures. Although ex ante hedge ratios are found to be characterised by intertemporal instability, ex ante hedging performance of direct hedges and cross hedges approaches that of the ex post benchmark when hedge ratios are estimated using a sufficient window size.     

Trading House Price Risk with Existing Futures Contracts

This paper examines the use of futures contracts to hedge residential real estate price risk. We examine whether existing futures contacts can effectively be used to offset volatility in national house prices. Little evidence of any simple systematic relation between national prices and futures prices is found. Since house prices are not easily replicated with a portfolio of existing futures contracts, a further implication is that the Chicago Mercantile’s introduction of a financial asset whose value reflects house prices will help complete the market. Nevertheless, the success of the CME’s new derivative contracts may be limited in light of state and regional house price correlations.

Asset Pricing and Hedging in Financial Markets with Transaction Costs: An Approach Based on the Von Neumann–Gale Model

The paper develops a general discrete-time framework for asset pricing and hedging in financial markets with proportional transaction costs and trading constraints. The framework is suggested by analogies between dynamic models of financial markets and (stochastic versions of) the von Neumann–Gale model of economic growth. The main results are hedging criteria stated in terms of “dual variables” – consistent prices and consistent discount factors. It is shown how these results can be applied to specialized models involving transaction costs and portfolio restrictions.     

Financial Leverage,CEO Compensation,and Corporate Hedging: Evidence from Real Estate Investment Trusts

This paper studies the determinants of corporate hedging practices in the REIT industry between 1999 and 2001. We find a positive significant relation between hedging and financial leverage, indicating the financial distress costs motive for using derivatives in the REIT industry. Using estimates of the Black–Scholes sensitivity of CEO’s stock option portfolios to stock return volatility and the sensitivity of CEO’s stock and stock option portfolios to stock price, we find evidence to support managerial risk aversion motive for corporate hedging in the REIT industry. Our results indicate that CEO’s cash compensation and the CEO’s wealth sensitivity to stock return volatility are significant determinants of derivative use in REITs. We also document a significant positive relation between institutional ownership and hedging activity. Further, we find that probability of hedging is related to economies of scale in hedging costs.

Hedging House Price Risk with CME Futures Contracts: The Case of Las Vegas Residential Real Estate

Until the recent introduction of real estate futures on the Chicago Mercantile Exchange (CME), there have been few opportunities to manage house price risk. This paper examines whether house price risk can be effectively hedged in Las Vegas, one of the CME contract cities. The analysis considers hedging from the viewpoint of real estate investment groups, mortgage portfolio investors, builder/developers and individual homeowners. For investment groups and mortgage holders holding a mix of new and existing home assets, CME futures would have reduced house price risk by more than 88% over the 1994–2006 period. Similarly, homeowners implicitly hedging price volatility of existing homes also would have fared well over the sample period. However, builder/developers worried about new home price appreciation would have been much less successful in managing their risk. One important caveat, minimum variance hedge ratios change over time and may cause hedge performance to suffer.

Futures-Style Options on Euro-deposit Futures: Nihil sub Sole Novi?

Euro-deposit futures play a relevant role among the derivative products traded in official markets. As opposed to most futures contracts, the underlying instrument is not represented by a traded asset but by a linear transformation of an interest rate, the Libor. The options written on Euro-deposit futures that are traded at the London International Financial Futures & Options Exchange (LIFFE) are subject to daily marking to market, as the underlying futures; thus, they are called futures-style options or pure futures options. These options are often priced with the Black (1976) formula, whose use entails several shortcomings. A more realistic alternative is represented by the univariate Cox, Ingersoll and Ross (1985) model. The closed-form solutions for the prices of Euro-deposit futures and futures-style options on Euro-deposit futures obtained in the CIR model are two major original contributions presented in this paper. Other original contributions involve the determination of the relation between futures rates and forward rates and the derivation of the equivalent portfolio for the hedging of futures-style options on Euro-deposit futures.     

A Time-Series Model of Stock Returns with a Positive Short-Term Correlation and a Negative Long-Term Correlation

We study portfolio stock return behavior that exhibits both a positive autocorrelation over short horizons and a negative autocorrelation over long horizons. These autocorrelations are more significant in small size portfolios. Among various forms of temporary components in stock prices, an AR(2) component is the simplest model compatible with this pattern of returns, which yields an ARMA(2,2) model of stock returns. We show that the significance of this model is that it requires the presence of feedback trading, which is a form of irrational trades, and the market's slow adjustment to the market fundamentals, which is consistent with recent modelings of stock prices. We find that the variation of the temporary component becomes greater as the firm size gets smaller. This implies that the deviation from the market fundamentals is larger in small size portfolios than in large size portfolios.     

Efficient Greek Calculation of Variable Annuity Portfolios for Dynamic Hedging: A Two-Level Metamodeling Approach

The financial risk associated with the guarantees embedded in variable annuities cannot be addressed adequately by traditional actuarial techniques. Dynamical hedging is used in practice to mitigate the financial risk arising from variable annuities. However, a major challenge of dynamical hedging is to calculate the dollar Deltas of a portfolio of variable annuities within a short time interval so that rebalancing can be done on a timely basis. In this article, we propose a two-level metamodeling approach to efficiently estimating the partial dollar Deltas of a portfolio of variable annuities under a multiasset framework. The first-level metamodel is used to estimate the partial dollar Deltas at some well-chosen market levels, and the second-level metamodel is used to estimate the partial dollar Deltas at the current market level based on the precalculated partial dollar Deltas. Our numerical results show that the proposed approach performs well in terms of accuracy and speed.     

A Benchmark Approach to Portfolio Optimization under Partial Information

This paper proposes a filtering methodology for portfolio optimization when some factors of the underlying model are only partially observed. The level of information is given by the observed quantities that are here supposed to be the primary securities and empirical log-price covariations. For a given level of information we determine the growth optimal portfolio, identify locally optimal portfolios that are located on a corresponding Markowitz efficient frontier and present an approach for expected utility maximization. We also present an expected utility indifference pricing approach under partial information for the pricing of nonreplicable contracts. This results in a real world pricing formula under partial information that turns out to be independent of the subjective utility of the investor and for which an equivalent risk neutral probability measure need not exist.      

Cointegration Analysis of Audit Pricing Model: A Panel Unit Root Test Approach

In this study, we provide evidence on the stationarity of real audit fees and the major explanatory variables frequently used in the audit pricing models from a pooled data set, using panel unit root tests developed by Im et al. (1997). The panel unit root test supports the hypothesis of non‐stationarity of audit fees and their major determinants. We demonstrate that variables in the audit pricing model that were previously found to have impact on audit fees may turn out to be useless when more powerful tests like panel tests are applied to these variables. Our evidence implies that failing to employ appropriate procedure to test cointegration and to specify the appropriate model for audit fees and their determinants would generate results that may have exaggerated the effects of some variables on audit fees.     

Menu costs and Markov inflation: A theoretical revision with new evidence

We revisit a foundational theoretical paper in the menu-cost literature, Sheshinski and Weiss [1983. Optimum pricing policy under stochastic inflation. Review of Economic Studies 50(3), 513-529], one of the few to treat stochastic inflation with persistent deviations from trend. In contrast to the original finding, we show that optimal pricing in this environment entails using different (s,S) bands in high-inflation and low-inflation states of the world. The low-inflation band is strictly contained within the high-inflation band. This revised solution has very different implications from the original one. Firms are generally risk loving, not risk averse, with respect to inflation. An increase in the variance of inflation increases price dispersion when inflation is high and decreases price dispersion when inflation is low. On an aggregate level, this optimal pricing would lead to bunching of prices and non-neutrality of money in the setting of Caplin and Spulber [1987. Menu costs and the neutrality of money. Quarterly Journal of Economics 102(4), 703-725]. To test the main finding, we construct an establishment-level dataset from the months surrounding Mexico's “tequila crisis” in 1995. In the high-inflation state, price increases are larger and establishments allow their prices to vary more widely around their respective long-run mean relative prices. Cross-establishment price dispersion is lower, but this result seems due to decreased establishment heterogeneity rather than narrower (s,S) bands. Overall, the evidence suggests that establishments employ wider (s,S) bands in the high-inflation state.     

Binomial option pricing with stochastic parameters: A beta distribution approach

This research extends the binomial option-pricing model of Cox, Ross, and Rubinstein (1979) and Rendleman and Barter (1979) to the case where the up and down percentage changes of stock prices are stochastic. Assuming stochastic parameters in the discrete-time binomial option pricing is analogous to assuming stochastic volatility in the continuous-time option pricing. By assuming that the up and down parameters are independent random variables following beta distributions, we are able to derive a closed-form solution to this stochastic discrete-time option pricing. We also derive an upper and a lower bounds of the option price.     

A generalized approach to optimal hedging with option contracts

In this paper, we develop a theoretical model in which a firm hedges a spot position using options in the presence of both quantity (production) and basis risks. Our optimal hedge ratio is fairly general, in that the dependence structure is modeled through a copula function representing the quantiles of the hedged position, and hence any quantile risk measure can be employed. We study the sensitivity of the exercise price which minimizes the risk of the hedged portfolio to the relevant parameters, and we find that the subjective risk aversion of the firm does not play any role. The only trade-off is between the effectiveness and cost of the hedging strategy.