A note on the hedging effectiveness of GARCH models |
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| Authors: | Donald Lien |
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| Institution: | 1. Newhuadu Business School, Minjiang University, Fuzhou 350108, China;2. Collaborative Innovation Center for Energy Economics and Energy Policy, China Institute for Studies in Energy Policy, Xiamen University, Xiamen, Fujian, 361005, PR China;3. China Center for Energy Economics Research, College of Economics, Xiamen University, Xiamen 361005, China;4. Department of Economics, University of Liberia, Capitol Hill, Monrovia, Liberia;5. Wang Yanan Institute for Studies in Economics, Xiamen University, Xiamen 361005, China;6. School of Business, University of Cape Coast, Cape Coast, Ghana;1. University of Minho and NIPE, Campus de Gualtar, 4710-057 Braga, Portugal;2. CREATES and Aarhus University, Department of Economics and Business, Fuglesangs Allé 4, DK-8210 Aarhus V, Denmark;1. Indian Institute of Management Lucknow, Uttar Pradesh, India;2. Indian Institute of Management Raipur, Chhattisgarh, India;1. Dept. of Economics, East West University, Dhaka, Bangladesh;2. Fikra Research & Policy, PO Box 2664, Doha, Qatar;3. Schulich School of Business, York University, 4700 Keele Street, Toronto, ON M3J 1P3, Canada |
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| Abstract: | This note compares the hedging effectiveness of the conventional hedge ratio and time-varying conditional hedge ratios (of which GARCH ratio is a special case). It is shown that, in large sample cases, the conventional hedge ratio provides the best performance. For small sample cases, a sufficiently large variation in the conditional variance of the futures return is required to produce the opposite result. The result is due to the fact that the hedging effectiveness measure is based upon the unconditional variance; meanwhile, the conventional hedge ratio minimizes the unconditional variance and the conditional hedge ratio aims at minimizing the conditional variance. |
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