An empirical analysis of dynamic multiscale hedging using wavelet decomposition |
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Authors: | Thomas Conlon John Cotter |
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Institution: | University College Dublin, , Blackrock, Co. Dublin, Ireland |
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Abstract: | This study investigates the hedging effectiveness of a dynamic moving‐window OLS hedging model, formed using wavelet decomposed time‐series. The wavelet transform is applied to calculate the appropriate dynamic minimum‐variance hedge ratio for various hedging horizons for a number of assets. The effectiveness of the dynamic multiscale hedging strategy is then tested, both in‐ and out‐of‐sample, using standard variance reduction and expanded to include a downside risk metric, the scale‐dependent Value‐at‐Risk. Measured using variance reduction, the effectiveness converges to one at longer scales, while a measure of VaR reduction indicates a portion of residual risk remains at all scales. Analysis of the hedge portfolio distributions indicate that this unhedged tail risk is related to excess portfolio kurtosis found at all scales. |
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