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RESEARCH PROJECT

On

RATIO ESTIMATION”

Submitted in partial fulfillment of the requirement for MBA

Degree of Bangalore University

BY

Shivaraj.G

Registration Number

04XQCM6086

Under the guidance of

Prof.B.V.Rudramurthy

Associate Bharatiya Vidya Bhavan

Bangalore-560001

2004-2006

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

DECLARATION

HEDGING AND HEDGE RATIO ESTIMATION” is prepared under the guidance of

Prof.B.V.Rudramurthy in partial fulfillment of MBA degree of Bangalore University,

and is my original work.

This project does not form a part of any report submitted for degree or diploma

under Bangalore University or any other university.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

PRINCIPAL’S CERTIFICATE

formed a basis for the award of any degree/diploma for any other university.

Date: PRINCIPAL

MPBIM, Bangalore

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

GUIDE’S CERTIFICATE

supervision.

I also certify that he has fulfilled all the requirements under the covenant

governing the submission of dissertation to the Bangalore University for the award of

MBA Degree.

MPBIM, Bangalore

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

ACKNOWLEDGEMENT

the contributing personalities who both assisted and inspired and lead us to visualize the

things that turn them into successful stories for our successors.

First of all I thank the Almighty God for his grace bestowed on us throughout this

project.

with the timely advice and expertise and has helped remarkably to complete the project.

Last, but not the least, I would like to thank my Parents and all my Friends for their

SHIVARAJ.G

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

NO.

ABSTRACT

1. INTRODUCTION:

¾ THOEORETICAL CONSIDERATIONS

2. LITERATURE REVIEW:

3. RESEARCH METHODOLOGY:

¾ PROBLEM STATEMENT

¾ OBJECTIVES

¾ SCOPE OF THE STUDY

¾ LIMITATIONS

¾ DATA AND SAMPLE OF DATA

¾ METHODOLOGY

4. DATA ANALYSIS:

COINTEGRATION.

¾ RESULTS FROM OLS.

¾ RESULTS FROM ECM.

¾ TABLES.

¾ GRAPHS.

5. CONCLUSION:

REFERENCES:

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Abstract:

This research project investigates the hedging effectiveness of the NIFYT AND

CNXIT stock index futures contract using weekly settlement prices for the period April

2001 to March 2006 and August 2003 to March 2006 respectively. Particularly, it focuses

on three areas of interest: the determination of the appropriate model for estimating a

hedge ratio that minimizes the variance of returns; the hedging effectiveness and the

stability of optimal hedge ratios through time; an in-sample forecasting analysis in order

to examine the hedging performance of different econometric methods. The hedging

performance of this contract is examined considering alternative methods, i.e. Ordinary

Least Square method and Error Correction Model, for computing more effective hedge

ratios. The results suggest the optimal hedge ratio that incorporates nonstationarity, long

run equilibrium relationship and short run dynamics is reliable and useful for hedgers.

Comparisons of the hedging effectiveness and hedging performance of each model imply

that the error correction model (ECM) is superior to the other models employed in terms

of risk reduction.

In this study we have estimated the hedge ratios using both the methods and compared

both the methods, the hedge ratio obtained from the ECM is better compared to the OLS

method. And the Adjusted R-sqr measures the effectiveness of hedge ratios determined

through the OLS AND ECM methods.

Finally, the results showed that CNXIT index futures contracts are better instrument

for hedging and also on minimizing the market risk over the time. And also CNXIT index

futures contracts reveals the better adjusted R-sqr results in both the methods compared

to the NIFYT index futures contract.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Introduction.

The basic motivation for hedging is to reduce or eliminate the variability of profits and

firm value that arises from market changes. The effectiveness of a hedge becomes

relevant only in the event of significant change in the value of the hedged item. A hedge

is effective if the price movements of the hedged item and the hedging derivative roughly

offset each other.

Hedging through trading futures is a process used to control or reduce the risk of

adverse price movements. The introduction of stock index futures contracts offer the

market participants the opportunity to manage the market risk of their portfolios without

changing the portfolios composition.

states that the objective of a hedge is to minimize the risk”. Howard and D’Antonio

(1984) define hedging effectiveness as the ratio of the excess return per unit of risk of the

optimal portfolio of the spot commodity and the futures instrument to the excess return

per unit of risk of the portfolio containing the spot position alone (see also, Pennings and

Meulenberg, 1997). Hsin et al. (1994) measure hedging effectiveness by considering both

risk and returns in hedging.

However the statement “futures contracts do not introduce risk” is not correct.

what extent hedgers are able to reduce cash price risk by using futures contracts. First,

Markowitz (1959) measures the hedge effectiveness as the reduction in standard

deviation of portfolio returns associated with a hedge. Then, Ederington1 (1979),

following the work of Working (1953), Johnson (1960) and Stein (1961), measures

hedging effectiveness as the percentage reduction in variability. “He explains that a

hedge is effective if the R-squared of the Ordinary Least Square regression explaining the

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

data is high, say 90%. But a high R-squared by itself is not always a reliable indicator of

hedging effectiveness. However a R-sqr of > 50% shall be eligible for testing.

All previous studies, which investigate measures of hedging effectiveness, use the

simple Ordinary Least Squares Regression (OLS) for estimating hedge ratios. However,

there is wide evidence that the simple regression model is inappropriate to estimate hedge

ratios since it suffers from the problem of serial correlation in the OLS residuals and the

heteroskedasticity often encountered in cash and futures price series. So, to counter the

problem of inconstant variances of index futures and stock index prices, a number of

papers measure optimal hedge ratios via autoregressive conditional heteroskedastic

processes which allow for the conditional variances of spot and futures prices to vary

over time. A second problem encountered when estimating hedge ratios arises from the

cointegrative nature between spot and futures markets. If no account is made for the

presence of cointegration it can lead to an under-hedged position due to the

misspecification of the pricing behavior between these markets.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Theoretical considerations:

Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures

contracts are based on the popular market benchmark S&P CNX NIFTY index.

NSE defines the characteristics of the futures contract such as the underlying index,

market lot, and the maturity date of the contract. The futures contracts are available for

trading from introduction to the expiry date.

S&P CNX Nifty is a well diversified 50 stock index accounting for 25 sectors of the

economy. It is used for a variety of purposes such as benchmarking fund portfolios, Index

based Derivatives etc.

S&P CNX Nifty is owned and managed by Indian Index Services and Products Ltd

(IISL), which is a joint venture between NSE and CRISIL. IISL is India's first specialized

company focused upon the index as a core product. IISL have a consulting and licensing

agreement with Standard & Poor's (S&P), who are world leaders in index services.

The average total traded value for the last six months [from Nov 2005 to May 2006]

of all Nifty stocks is approximately 49.8% of the traded value of all stocks on the NSE

Nifty stocks represent about 56.5% of the total market capitalization as on March 31,

2006.

Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is 0.07%

S&P CNX Nifty is professionally maintained and is ideal for derivatives trading.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Hedging:

Hedging operations exist to reduce or eliminate risk arising from the fluctuation in the

price of the underlying asset.

markets, hedging means eliminating the risk in an asset or a liability. Applied to stock

market, hedging means eliminating the risk in a investment portfolio. Since hedging is

explained in terms of risk, let us explain what risk is.

It is the uncertainty of an expected future event. The uncertainty may turn out to be

favourable or unfavorable. Risk is thus a neutral concept: profit and loss are merely two

sides of the same coin called risk. Since hedging eliminates risk, it follows that hedging

shuts the door closed to profit as well as loss: the investment is locked at a particular

value, and it neither gains nor looses in value from subsequent price changes.

HEDGERS SPECULATORS

Hedgers are parties who are exposed to risk Speculators do not have a prior

because they have a prior position in the position that they want to hedge

commodity or the financial instrument against price fluctuations. They buy

specified in the futures contract. By taking an or sell futures contracts in an attempt

opposite position in the futures market, to earn a profit. Rather they willing

parties who are at risk with an asset can to assume the risk of price

hedge their position. By doing so, they can fluctuation in the hope of profiting

shield themselves against the risk of from them.

unexpected price changes.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Cross hedging:

A cross hedge is one in which the cash asset and the asset underlying the futures contract

are not identical. This situation arises when the hedger uses a futures contract with an

underlying asset different from the one he is currently long or short. For example,

consider a hedger who uses S&P 500 futures contracts to hedge against a decline in the

value of his portfolio, which is different from the 500 component stocks in the S&P 500.

Sometimes there are no available futures or market for currencies. In these cases, the risk

managers might wish to use a substitute or proxy for underlying currency that is

available. Use of proxy instrument for hedging underlying assets is known as cross

hedging

Cross hedger would like go through a simple 2 steps process to determine the optimal

cross hedge: first, find the currency futures most highly correlated with the actual

currency of exposure. Second, find the optimal hedge ratio using the covariance between

proxy futures and actual currency.

Hedging is one of the three principal ways to manage risk, the others being

diversification and insurance. Let us bring out the distinction between the three.

Diversification minimizes risk for a given amount of return. Hedging eliminates both

sides of risk: the potential profit and the potential loss: Insurance resolves risk into profit

and loss, and eliminates the loss while retaining the profit.

Hedging is implemented by adding a negatively and perfectly correlated asset to an

existing asset. Insurance for investment is achieved by buying a put option on the

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

investment. Diversification and hedging do not have cost in cash but may have

opportunity cost. Insurance, on the other hand has explicit cost incurred in cash.

Index futures is the most popular and useful medium for hedging in stock market. This is

in contrast to commodity and currency markets where it is not useful. The reason is that

commodity and currencies are primarily consumed and are not substitutable with each

other. In contrast, stocks are held for investment and can be substitutable with each other.

Since the stock index comprises many stocks, it acts as a good substitute or proxy for

many investment portfolios. With one index representing the stock market as a whole, the

transaction costs will be minimal and the administrative work is lesser. This is the reason

why stocks are physical securities but do not have futures contract; and index is a

derivative and index futures is derivative on derivative. To sum up, we can use the same

index futures for hedging any investment portfolio.

As a general rule, a buy position or "long" in the underlying asset is covered by a sell

position or "short" position in futures. Conversely, a "short" position in the underlying

asset is covered by a buy position or "long" in futures.

The greater the correlation between the changes in prices of the underlying asset and the

futures contract the more effective is the hedge. As such, the loss in one market is

partially or totally compensated by the profit in the other market, given that the traded

positions are equal and opposite.

It is very important to note that hedging does not necessarily improve the financial

outcome, it just reduces the uncertainty. In practice, hedging is not perfect; because of the

basis risk which arises due to the following reasons:

i. The asset being hedged might be different than the one underlying the futures

contract, i.e. using a 30y T-bill to hedge a 10y T-note;

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

ii. The hedger might be uncertain about the exact time that the delivery has to take

place, i.e. a new oil ring that is expected to start extracting next summer, without

knowing exactly when; and

iii. The futures contract matures after the delivery date that the hedger has in mind,

i.e. the hedger needs to buy steel in January but steel futures expire on March.

Where S(t) is the spot price of the underlying asset and F(t,T) is the price of the futures

contract that has been utilized. If the asset to be hedged is the same as the one underlying

the futures, then the basis on expiration is equal to zero. If the delivery date is not the

same as the one that the futures matures, then the basis will signify the ``losses'' or

``gains'' of the hedge than are not known when the hedge is constructed.

Example. (Basis risk: different maturities) Today, the gold price isS(t). Say that one

has to deliver gold at time , and in order to hedge takes a short position on a futures

contract that matures at time T>t. The price of this contract is equal to F(t,T) , and the

basis today is :

.

The basis on the delivery date will be

,

Will indicate the gains [or losses] due to the hedge. See Figure.1 for a visual

representation of the basis risk.

Figure.1

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Basis risk

Generally speaking, the basis risk arises from uncertainty about the future interest rates

and uncertainty about the future yields of the underlying asset. For investments that are

difficult or costly to store, the basis risk might increase substantially. The delivery month

that is as close as possible -but not earlier than, the date when the hedge matures.

In considering the use of futures contracts to hedge an established spot position the

investor must decide on the hedge ratio, h , to be employed. The hedge ratio is the ratio of

the number of units traded in the futures market to the number of units traded in the spot

market. The particular hedging strategy adopted depends crucially on the investor’s

objectives. Research has concentrated on three hedging strategies: the traditional one-to

one; the beta hedge; and the minimum variance hedge proposed by Johnson (1960) and

also associated with Ederington (1979).

The traditional strategy emphasizes the potential for futures contracts to be used to

reduce risk. It is a very simple strategy, involving the hedger in taking up a futures

position that is equal in magnitude, but opposite in sign to the spot market position, i.e. h

= -1. If proportionate price changes in the spot market matches exactly those in the

futures market, the price risk will be eliminated. However, in practice, it is unlikely for a

perfect correlation between spot and future returns to exist, and hence the hedge ratio that

minimizes the variance of returns will definitely differ from –1. Beta hedge ratio simply

refers to the portfolio’s beta.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

The beta hedge has the same objective as the traditional 1:1 hedge that establishes a

futures position that is equal in size but opposite in sign to the spot position. Yet, when

the cash position is a stock portfolio, the number of futures contracts needed for full

hedge coverage needs to be adjusted by the portfolio’s beta. In many cases the portfolio

to be hedged will be a subset of the portfolio underlying the futures contract, and hence

the beta hedge ratio will deviate from –1. However, it may be the case that the futures

contract may mirror the portfolio to be hedged, and thus the beta hedge ratio will be the

same as the traditional hedge ratio.

whether mean futures returns are zero; if they are not, hedging may be too expensive’.

Johnson (1960) proposed the minimum variance hedge ratio (MVHR) as an alternative

to the classic hedge. He applied modern portfolio theory to the hedging problem. It was

the first time that definitions of risk and return in terms of mean and variance of return

were employed to this problem. Johnson maintained the traditional objective of risk

minimization as the main goal of hedging but defined risk as the variance of return on a

two-asset hedged portfolio. The MVHR (h*) is measured as follows:

cov(ΔS,ΔF)

h* =

var(ΔF)

Where,

F and S represent the relative amount invested in futures and spot respectively,

cov(ΔS,ΔF) is the covariance of spot and futures prices changes, and var(ΔF) is the

variance of futures price changes. It should be mentioned that the minimum variance

hedge is the coefficient of the regression of spot price changes on futures price changes.

The negative sign reflects the fact that in order to hedge a long stock position it is

necessary to go short (i.e. sell) on futures contracts. Using the MVHR assumes that

investors are infinitely risk averse. While such an assumption about risk-return trade-off

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

hedging performance.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

LITERATURE REVIEW:

EFFECTIVENESS: THE CASE OF THE S&P 500 STOCK” market index futures

contract:

[Department of Economics, University of Athens, 5 Stadiou Street, Office 115,

10562 Athens, Greece]

This paper investigates the hedging effectiveness of the Standard & Poor’s

(S&P) 500 stock index futures contract using weekly settlement prices for the period

July 3rd, 1992 to June 30th, 2002. Particularly, it focuses on three areas of interest: the

determination of the appropriate model for estimating a hedge ratio that minimizes the

variance of returns; the hedging effectiveness and the stability of optimal hedge ratios

through time; an in-sample forecasting analysis in order to examine the hedging

performance of different econometric methods. The hedging performance of this contract

is examined considering alternative methods, both constant and time-varying, for

computing more effective hedge ratios. The results suggest that the optimal hedge ratio

incorporates nonstationary, long run equilibrium relationship and short run dynamics is

reliable and useful for hedgers. Comparisons of the hedging effectiveness and in-sample

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

hedging performance of each model imply that the error correction model (ECM) is

superior to the other models employed in terms of risk reduction.

Methodology:

This paper aims to determine the appropriate model when estimating optimal hedge

Ratios. The alternative models employed are the following:

This model is a linear regression of change in spot prices on changes in futures

Prices. Let St and Ft be logged spot and futures prices respectively, the one period

MVHR can be estimated as follows:

Where u(t) is the error from the OLS estimation, ΔSt and ΔFt represent spot and futures

Price changes and the slope coefficient β is the optimal hedge ratio (h*).

Engle and Granger (1987) stated that if sets of series are cointegrated, then there

exists a valid Error Correction Representation of the data. Thus, if St represents the

index spot price series and Ft the index of futures price series and if both series are I

(1), there exists an error correction representation of the following form:

where ut-1 = St-1 – [a0 + a1Ft-1] is the error correction term and has no moving average

part; the systematic dynamics are kept as simple as possible and enough lagged

variables are included in order to ensure that et is a white noise process; and the

coefficient β is the optimal hedge ratio.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

GARCH model, that parameterizes volatility as a function of unexpected information

shocks to the market. The equation for GARCH is the following:

…………(1)

The equation specified above is a function of three terms: the mean α0, news about

volatility from the previous period, measured as the lag of the squared residual from the

mean equation e^2t-1 (the ARCH term), and last period's forecast variance σ^2t-1 (the

GARCH term). The more general GARCH (p, q) calculates σ^2t from the most recent p

observations on e^2 and the most recent q estimates of the variance rate.

to unity implies that the persistence in volatility is high. In other words, in order to

intercept expression (1), suppose that there is a large positive shock et-1, and hence e^2t-1

Where ϖ, α, β, ϒ are constant parameters. The left- hand side is that of the conditional

variance. This implies that the leverage effect is exponential, rather than quadratic, and

that forecasts for the conditional variance are guaranteed to be nonnegative. Since ,

effects can be tested be the hypothesis that ϒ > 0. if the leverage effect term ϒ, after

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

running the appropriate regression, is negative and statistically different from zero, this

will imply that positive shocks generate less volatility than shocks(bad news).

Comparisons are then made of the hedging effectiveness associated with each hedging

strategy based on the minimum variance hedge ratio estimations, using the simple OLS,

the ECM, the ECM with GARCH errors and the GARCH and EGARCH models. The

question of the appropriate model to use when estimating the optimal hedge ratio of the

S&P 500 index futures contracts traded in the US is of considerable interest to investors

wishing to use this contract for hedging

are given. Investors are usually concerned with how well they have done in the past.

Therefore, the in-sample hedging performance is a sufficient way to evaluate the hedging

performance of alternative models employed to obtain the optimal hedge ratio. The

measures that are most used to identify how well individual variables track their

corresponding series are the Root Mean Square Errors (RMSEs), Mean Absolute Errors

(MAEs) and Mean Absolute Percent Errors (MAPEs).

Finally, the issue of the stability of the estimated hedge ratio is also examined in this

study using the Chow’s breakpoint test for the superior model. They apply the Chow’s

breakpoint test by examining parameter consistency from 19/3/1999 onwards.

Conclusions:

This paper estimated optimal hedge ratios and examined the hedging effectiveness of

the S&P 500 index using alternative models, both constant and time-varying, over the

period from July 1992 to June 2000. The findings of this study suggest that in terms of

risk reduction the error correction model is the appropriate method for estimating optimal

hedge ratios since it provides better results on both slope as well as adjusted R-sqr in

comparison with the conventional OLS method, the ECM with GARCH errors, the

GARCH model, and the EGARCH model.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

The evidence presented in this paper strongly suggests that the S&P 500 stock index

futures contract is an effective tool for hedging risk. This is consistent to earlier studies

on S&P 500 index covering the 1980s and early 1990s. Hence, the introduction of this

contract has given portfolio managers and investors a valuable financial instrument by

which they can avoid risk at times they wish to do this without liquidating their spot

position or changing their portfolios composition.

HEDGING EFFECTIVENESS IN GREEK STOCK INDEX FUTURES MARKET:

[Department of Economics, University of Portsmouth, Locksway Road, Portsmouth, PO4

8JF, UK.]

This paper examines hedging effectiveness in Greek stock index futures market. It

focus on various techniques to estimate variance reduction from constant and time-

varying hedge ratios. For both available stock index futures contracts of the Athens

Derivatives Exchange (ADEX), they employ a variety of models to derive and estimate

the effectiveness of hedging.

It measure hedging effectiveness using three different methods: (i) the OLS method,

(ii) the method of minimum variance hedge ratio, Ederington (1979), and (iii) the method

suggested by Park and Switzer (1995) where ,

σ^2(Unhedged) – σ^2(hedged)

HE = ______________________________

σ^2(Unhedged)

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

. In both cases for Greek stock index futures, the hedge ratio from M-GARCH model

provides greater variance reduction, in line with similar findings in the literature. These

findings are helpful to risk managers dealing with Greek stock index futures.

Methodology:

(1959), the method of Ederington (1979), the measures of Howard and D’Antonio (1984,

1987), and the Lindahl’s (1991) measure.

An early measure of hedge effectiveness comes from Markowitz (1959). He measures

hedging effectiveness in accordance with the reduction in standard deviation of portfolio

returns associated with a hedge. In this case, the greater reduction in risk, the greater is

the hedging effectiveness.

ΔS = c + bΔF + u

He shows that a hedge is effective if the R-squared of the regression line explaining

the data is high. In other words, the higher the R-squared, the greater the effectiveness of

the minimum variance hedge.

However, the effectiveness of the minimum-variance hedge can be determined by

examining the percentage of risk reduced by the hedge (Ederington, 1979; Yang, 2001).

Hence, the measure of hedging effectiveness is also defined as the ratio of the variance of

the unhedged position minus the variance of the hedged position, over the variance of the

unhedged position.

σ^2(Unhedged) – σ^2(hedged)

HE = ______________________________

σ^2(Unhedged)

models. Since the selection of the measure of hedge effectiveness has a considerable

impact on the assessment of hedged portfolios, they measure hedging effectiveness of

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Greek stock index futures markets using Model (1), Model (2) and Model (3). To do so,

the hedge ratios obtained from the methods of OLS, ECM, and BGARCH are considered.

Conclusion:

In this paper they investigate the hedging effectiveness of Greek stock index

futures contracts. (FTSE/ASE-20 and FTSE/ASE Mid 40). To do so, they compare

several techniques of measuring hedging effectiveness. In particular, they measure

hedging effectiveness of Greek stock index futures markets using three different

methods: (i) the OLS model, (ii) the measure of hedging effectiveness which is defined as

the ratio of the variance of the unhedged position minus the variance of the hedged

position, over the variance of the unhedged position, and(iii) the method suggested, and

applied, by Park and Switzer (1995) and Kavussanos and Nomikos (2000).

The primary objective of this paper is to examine whether the hedge ratios calculated

from several methods generate better results in terms of hedging effectiveness To do so,

the hedge ratios obtained from these methods of OLS, ECM, and BGARCH are

considered.

First, the results from the OLS model show that the R-sq. value of FTSE/ASE-20 is

much higher than that of FTSE/ASE Mid 40. Therefore, the FTSE/ASE-20 index

provides larger risk reduction. Furthermore, the second method indicates that the

FTSE/ASE-20 contract produces the most effective hedges. In this case, for both

contracts the OLS hedge ratio provides greater variance reduction. Then, following the

papers of Park and Switzer (1995) and Kavussanos and Nomikos (2000), we show that

the BGARCH hedge ratio provides greater variance reduction than the other models. So,

the hedge ratio obtained from the Bivariate cointegration GARCH model generates better

results in terms of hedging effectiveness. This is in accordance with Park and Switzer

(1995), Kavussanos and Nomikos (2000) and Yang (2001). Finally, they measure the

hedging effectiveness by considering the hedging performance for the post-sample

periods. Using forecasting statistics for OLS model and ECM, they find that the root

mean squared error of ECM is lower than that of OLS for both indices. Hence, the ECM

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

outperforms the OLS (conventional) model, and therefore, the error correction model

(ECM) is superior to the conventional model. This is consistent with Chou et al. (1996).

STOCK INDEX FUTURES: (1984) Journal of Finance . Vol. 39. (657-669).

According to STEPHEN FIGLEWSKI the return and risk for an index futures hedge will

depend upon the behavior of the “ basis” i.e. , the difference between the futures price

and the cash price.

In general basis risk arises simply because the connection between the futures market

and the cash market is imperfect, except at maturity of the futures contract.

Basis risk can arise from a number of different sources and is a more significant problem

for stock index co tracts than for other financial futures, like treasury bills and bonds. The

most apparent cause of basis risk is the nonmarket component of return on the cash stock

position.

In this paper they examine the basis and the different sources of basis risk on the

Standard and Poor’s 500 index contracts.

Methodology:

In this paper they have used constant hedge ratio and variable hedge ratio.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

h* = σpf/σ^2f

To examine how effective stock index futures hedges would have been in reality, they

have calculated the risk and return combinations which could have been achieved by

selling standard and Poor’s 500 futures against the underlying portfolio of five major

stock indexes over one week holding periods.

To examine the dynamic of the basis, they ran regression of the change in the basis on the

deviation from the theoretical value and the change in the spot index.

Conclusion:

Finally, they have observed that, a more effective hedge may be achievable with a more

specialized instrument, such as industry group index futures. Another observation was

that the risk minimizing hedge ratio was in all cases smaller then the beta of the portfolio

being hedged, contrary to what has been suggested elsewhere.

In considering the sources of basis risk in a hedge of the S&P portfolio itself, they

found that dividend risk was not an important factor, while hedge duration and time to

expiration of the futures contract were, to some extent. One day hedges were subject to

substantially more basis risk than one week hedges, but there did not seem to be any

further improvement for extending the holding period to four week.

They found other evidence indicating that the character of the futures market has changes

over time in the fact that the speed of adjustment of the actual futures price toward the

theoretical level has increased. At present about 70 percent of a discrepancy is eliminated

in one day. Overall evidence points to the conclusion that the stock index futures market

is now fairly efficient and becoming more so with time.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

PRICES: Working paper by. American Economic Review , Vol 52, (431-459)

According to Holbrook research on futures markets during last 40 years has produced

results that have required drastic revision or replacement of a great part of the previously

accepted theory of futures markets and of the behavior, not only for futures prices, but of

the general class of prices behavior of businessmen including speculators, and on the

functioning of the price system.

Empirical research has played a leading role in the advancement of economic knowledge

and understanding that is described here, but the role has been a different one than

economist have ordinarily thought that such research would play in advancing their

science.

Futures markets have usually been regarded, in the past, as essentially speculative

markets. Although they rather early won recognition as useful for hedging, their hedging

use was treated as a fortunate by-product, neither necessary to the existence of such a

market, nor very closely related quantitatively to the amount of speculation on the

market.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Irwin undertook a study of the origins of futures markets in butter and eggs. Taking

advantage of the fact that there were then people still alive who had witnessed the early

stages of emergence of futures markets came from hedgers rather than from speculators.

According to the traditional concepts, hedging consists in matching one risk with an

opposing risk , and hedging in futures is effective because changes in spot prices of a

commodity tend to be accompanied by like changes in the futures price. The fact that

hedging usually involves more than risk avoidance has been known to hedgers

themselves and to some economists.

Quantitative studies, perhaps surprisingly, have contributed more to understanding of

hedging than have verbal inquires concerning business motivation. Particularly

noteworthy among these were studies of the quantitative relation between hedged

stockholding and market “carrying charges “, which brought recognition that much

hedging was done to assure profits, not merely to avoid risk

The traditional hedging concept represents the hedger as thinking in terms of possible

loss from his stockholding being offset by gain on the futures contracts held as a hedge ,

the carrying-charge hedger thinks rather in terms of change in “basis” , that is, change in

the spot futures price relation.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

5. JERPME L. STEIN:

THE SIMULTANEOUS DETERMINATION OF SPOT AND FUTURES PRICES:

Working paper: American Economic Review, Vol. 51 (1012-1025)

This paper develops a simple geometric technique for the simultaneous determination

of spot and futures prices in commodity markets:

The decision to hold hedged and unhedged stocks under pure competition:

The expected gain from holding unhedged stocks is equal to the spot price expected to

prevail at a later date (p*) minus the current spot price (p) minus the marginal net

carrying costs (m). There are two components of the marginal net carrying costs: the

marginal costs of storage and the marginal convenience yield, the later have a negative

element in carrying cost. The concept of the marginal convenience yield has been

developed by Brennan and Telser.

The variable p* is a stochastic variable. There is a probability that a capital loss will be

made on the holding of unhedged stocks.

Expected capital loss will be p*-p-m

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

When stocks are hedged, the owner incurs a liability of offset his holding of assets

(stocks). His liability is the sale of a futures contract, for the delivery of one of several

grades of a commodity sometime within the period of the futures contract.

The owner of hedged stocks does not intend to deliver a physical commodity in

fulfillment of his futures contract, but intends to repurchase a futures contract at the time

that he sells his inventory of stocks/ the expected gain from holding hedged stock is equal

to the expected gain from holding unhedged stocks minus the expected loss involved in

the sale and purchase of a futures contract.

h = (p*-p) - (q*-q) – m.

where ,

q is current price of futures contract

q* is price of the futures contract expected at a later date.

The optimum combination of hedged and unhedged stocks:

An owner of stock, for sale at an uncertain price, is assumed to allocate his holding

between hedged and unhedged stocks so as to maximize his expected utility. The method

of optimizing developed here is based upon James Tobin’s theory of liquidity preference.

As the portion of unhedged stock varies between zero and 100 percent, the expected

return per unit of stock varies from h to u. Risk is inherent in each form of stockholding,

where risk is defined as the situation whereby the owner may fail to receive his expected

return. Tobin used the standard deviation of the expected returns as his measure of risk.

Since he assumed that the probability density functions are symmetrical, a high standard

deviation or variance means a high probability of both negative and positive deviations

from the mean.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Market risk i.e. systematic risk of the portfolio can be reduced through

hedging. Hedging activity involves finding out of optimum hedge ratio and testing

hedge ratios. Hedging through trading futures is a process by which adverse price

movements can be controlled and reduced.

2. OBJECTIVES OF STUDY:

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

A portfolio is exposed to two kind of risks i.e. market risk and non market risk. One

can eliminate non market risk by creating an optimal portfolio. The problem is reduction

of market risk. Hence in this study we try to minimize the market risk by entering into

futures market with an appropriate hedge ratio. Our objective is to minimize the market

risk which is inevitable.

Hedging provides risk reduction facility and by choosing appropriate hedge ratio one

can protect their portfolio from the market risk. In our study we are testing the

effectiveness of the hedge ratios generated by different models and see whether the

hedge ratios generated by different models give optimal position.

A hedge using index futures removes the risk arising from market moves and leaves

the hedger exposed only to the performance of the portfolio relative to the market.

Futures contracts enable market participants to alter risks, which they face caused by

adverse and unexpected price changes. Hedging through future market is advantageous

because of its low cost.

This study is useful for those who are risk avers and those who wants to protect

themselves from the risk arising from the unexpected market movements. The study also

focuses on the effectiveness of the hedged portfolio and tests its effectiveness. The return

from the unhedged portfolio is exposed to unlimited market risk. However by hedging

the portfolio with appropriate hedge ratios one can minimize the unexpected market

moves.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

The data employed in this study comprises of 260 weekly observations on the

NIFTY stock index and stock index Futures contracts( 2001-2006) and 260 observations

on the CNXIT and stock index futures contracts(2003 Aug-2006 Mar).

Closing prices of spot indices are obtained from the www.yahoofinance.com

website and prowess Database, closing prices of futures contracts are obtained from

(www.nseindia.com).

STOCK EXCHANGE (NSE), selected from various sectors, while the CNXIT

comprises of 20 Companies, that have more than 50% of their turnover from IT related

activities like software development, hardware manufacture, vending, support and

maintenance.

Futures contracts are quoted on the NATIONAL COMMODITY AND DERIVATIVE

EXCHANGE.

NIFTY futures and CNX IT futures contracts have a maximum of 3-month trading

cycle - the near month (one), the next month (two) and the far month (three).

With effect from 28th May 2004 the Base value of CNXIT has changed from 100 to

100, to account for the above change in Base value, slicing technique has been adapted.

We have confined the analysis to the near month contract because preliminary research

showed that there was no much difference between the hedging properties of the nearest

and second contract. Also nearly all trading volume is in the near month so that liquidity

is much greater in that contract.

Weekly data are preferred in this study for several reasons. First, the choice of weekly

hedges is realistic and implies that hedgers in the market rebalance their futures positions

on a weekly basis. Second, the one week hedge can be used to reduce risk without

incurring excessive transactions costs.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Finally, the weekly hedging horizon is the most common choice of the prior empirical

studies in several derivatives markets. In all estimations the futures contract nearest to

expiration is used. In line with previous studies changes in logarithms of both spot and

futures price are analyzed, and no adjustment is made for dividends.

SAMPLE:

From the past 5 years data we have taken only weekly observation on the NIFTY

and NIFTY futures, 3 years CNXIT and CNXIT futures contracts.

NIFTY contains 50 India companies with large market capitalization and CNXIT

contains 20 companies which are into IT related activities.

In this study we have taken last 5 years closing prices of NIFTY and NIFTY INDEX

FUTURES CONTRACT and also CNXIT and CNXIT futures contracts.

In this study we have adopted 5 years weekly closing prices of NIFTY and NIFTY

futures contract, and 3 years for CNXIT and CNXIT index futures contract.

1. www.nseindia.com

2. www.yahoofinance.com

3. Prowess Database.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

METHODOLOGY:

Test of Stationary:

Ho: Series of Data are non stationary or series has unit root (ρ = 0)

H1: Series of Data are stationary or series does not have unit root (ρ < 1.)

The existence of unit roots is firstly tested using the Augmented Dickey-Fuller test

(ADF) (Dickey and Fuller, 1981) through the following relationship:

Δ St = α + βT + ρSt-1 + ΣγΔSt-1 + Ựt

Where ΔSt = St –St-1 , St is the index of the spot market, and k is chosen so that the

deviations ut to be white noise. The same relationship is used to determine the order of

the futures price index ( Ft ).

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Cointegration:

Evidence of price changes in one market generating price changes in the other market

so as to bring about a long-run equilibrium relationship is given below:

Ft – δ0 – δ1St = εt

Where Ft and St are contemporaneous futures and cash prices at time t; δ1 and δ0are

parameters; and εt is the deviation from parity. If Ft and/or St are nonstationary then

the Ordinary Least Square (OLS) method is inappropriate because the standard errors are

not consistent. This inconsistency does not allow hypothesis testing of the cointegrating

parameter δ1. If t F and t S are nonstationary but the deviations, εt , are stationary, Ft and

St are cointegrated and an equilibrium relationship exists between them (Engle and

Granger, 1987). For Ft and St to be cointegrated, they must be integrated of the same

order. Performing unit root tests on each price series determines the order of integration.

If each series is nonstationary in the levels, but the first differences and the deviations εt

are stationary, then the prices are cointegrated of order (1,1), denoted CI (1,1), with the

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

procedures are implemented: the Engle-Granger two-step methodology (Engle and

Granger, 1987) and the Johansen’s Maximum Likelihood approach (Johansen, 1988 and

1991).

1. Testing the existence of unit roots (integration order) in each index, following

Augmented Dickey-Fuller (ADF) test through equation.

2. Cointegration testing between stock index spot and futures market. Consider

prices (in log) in spot market i and futures market j ( Sti and Ftj), and Pt is the vector that

consist of Sti and Fti. According to Engle and Granger (1987), Sti, is said to be integrated

of order d, denoted Sti – 1 (d), if the dth difference of Sti, is stationery. The vector pt is said

integrated of order d-b, for b>0. If both Sti and Fti are I(1) and Pt-(CI(1,1), [ i.e. δ, Pt-I(0)]

, then there are error-correction equations in the following form:

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Where α1 and α2 are non-zero coefficients and εti and εtj are stationery, possibly

autocorrelated error terms. Engle and Granger proposed several cointegrateion tests:

however, the most preferable is the ADF statistic test.

R^2 measures the proportion of the total variation in y explained by the linear

combination of the regressors. The coefficients of determination express the proportion of

the total variation that has been explained or the relative reduction in variance when

measured about the regression equation rather than about the mean of the dependent

variable. if the value of r = 0.9 , R^2 will be 0.81 and this would mean that 81% of the

variation in the dependent variable has been explained by the independent variable

It is usually advisable to underhedge as your confidence in the future correlation between

ΔSt and ΔFt declines: that is , as the value of R^2 declines, trade fewer contracts than the

number called for by h*. If R^2 is below some arbitrary value, perhaps 0.5 , then it is

probably not wise to use that particular futures contract to hedge at all.

The method of ordinary least square is attributed to Carl Friedrich Gauss, a German

mathematician. This method is the cornerstone of most econometric theory. It makes 10

assumptions for two-variable regression.

parameters, as shown:

Yi = β1 + β2Xi + Ụi

the β’s . Hence linear regression will always mean a regression that is linear in the

parameters: the β’s . it may or may not be linear in the explanatory variables, the X’s.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

2. X values are fixed in repeated sampling: values taken by the regressor X are

considered fixed in repeated samples. More technically, X is assumed to be

nonstochastic.

The regression analysis is conditional regression analysis that is conditional on

the given values of the regressor X.

expected, value of the random disturbance term Ụi is zero. Technically, the

conditional mean value of Ụi is zero. Symbolically,

E(Ụi/Xi) = 0

This assumption states that the mean value of Ụi, conditional upon the given Xi,

is zero. The assumption E(Ụi/Xi) = 0 implies that E(Yi/Xi) = β1 + β2Xi. Therefore two

assumptions are equivalent.

4. Homoscedasticity or equal variance of Ụi: given the value of Xi, the variance

of Ụi is the same for all observations. That is, the conditional variances of Ụi are

identical. symbolically, we have

= E[Ụi^2/Xi]

= σ^2

5. No autocorrelation between the disturbances. given any two X values, Xi, and

Xj, the correlation between any two Ụi and Ụj is zero. symbolically we have

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

= E(Ụi/Xi)(Ụj/Xj)

= 0

= E(ỤiXi) - E(xi)E(Ụi)

= E(ỤiXi)

= 0

to be estimated. Alternatively, the number of observations n must be greater than the

number of explanatory variables.

8. Variability in X values: the X values in a given sample must not all be the same.

Technically, var(X) must be a finite positive number.

specification bias or error in the model used in empirical analysis.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

relationships among the explanatory variables.

This model is just a linear regression of change in spot prices on changes in futures

prices. Let St and Ft be logged spot and futures prices respectively, the one period

MVHR can be estimated as follow;

ΔSt = a0 + β.ΔFt + ưt

Where ưt is the error from the OLS estimation, ΔSt and ΔFt represent spot and futures

price changes and the slope coefficient β is the hedge ratio (h*).

The error correction mechanism first used by Sargan and later popularized by Engle and

Granger corrects for disequilibrium. An important theorem, known as the Granger

representation theorem, states that if two variables Y and X are cointegrated, then the

relationship between the two can be expressed as ECM.

Where ụt-1= St-1[a0 + a1Ft-1] is the error correction term and has no moving average

part; the systematic dynamics are kept as simple as possible and enough lagged variables

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

are included in order to ensure that εt is a white noise process: and the coefficient α1 is

the optimal hedge ratio.

The above equation states that ΔSt depends on ΔFt and also on the equilibrium error

term.

LIMITATIONS:

1. Only NIFTY and CNXIT have been selected for hedging.

2. The above study is limited to 5 years data for NIFTY and 3 years data for CNXIT.

3. The above study considers the effectiveness of hedging only through two models

i.e. OLS Models and ECM model.

4. Selected scrip’s are included in both indices.

5. the above study is focused only on two indices i.e. NIFTY and CNXIT.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

DATA ANALYSIS:

Tests for the presence of a unit root are performed by conducting the Augmented Dickey-

Fuller unit root rest under the assumption that there is no linear trend in the data

generated process

The series are tested at the 0 level and found stationery at 1% level, suggesting that the

series are stationery. The results for NIFTY, NIFTY INDEX FUTURES AND CNXIT,

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Diagrammatical representation of Stationarity is reported in Graphs1 and Graph 2.

Since we have identified that both our series, the spot prices (St) and future price (Ft)

of both the indices are I (0), then the presence or absence of cointegration can be

investigated by simply regressing the values of the spot asset (St) on the value of the

futures contracts (Ft). In particular a test for a unit root in the estimated residuals will

determine the presence or absence of cointegration. Table 5 and Table 6 Shows ADF test

results on residuals for both the indices. Since it shows that error term is I (0) in long run.

The results suggest that the spot NIFTY Index is cointegrated with the NIFTY Index

Futures and spot CNXIT Index is cointegrated with the CNXIT Index Futures contract.

We can easily see the cointegration of both indices with their respective index futures

contract in a graph Graph.3 and Graph 4.

Evidence in favour of a cointegrated system between weekly closing prices on the stock

index and weekly settlement prices on the stock index futures implies that both the cash

and the futures markets have a tendency to move together in the long run deviations from

equilibrium may be observed due to temporary disequilibrium forces.

ΔSt = a0 + β.ΔFt + ưt

Using conventional approach is presented as follows:

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

The slope coefficient β is the optimal hedge ratio. In our study it is more than 0.5 but not

close to unity hence results shows it is not highly significant. Prior research studies have

shown that, if the slope is close to unity then it is highly significant.

The Adjusted R-sqr is measure of good fit, but in out study R-sqr is 0.255 it is very less

[Table. 7].

The regression equation as follows:

The slope coefficient β is the optimal hedge ratio for CNXIT INDEX. In this study it is

near to unity hence it is significant. And adjusted R-sqr is 0.684 indicates good fit

[Table 8].

Comparison of hedge ratios and adjusted R-sqr for both NIFTY AND CNXIT are found

in [Table 11].

Both, the hedge ratio and adjusted R-sqr for CNXIT are greater then NIFTY, which

indicates better to go for CNXIT rather than NIFTY in case of hedging. And R-sqr

suggests effectiveness of hedge. But if we compare our study with prior studies both the

hedge ratios are not that much effective since both R-sqr’s are below 0.8.

Prior studies suggest that R-sqr should be between 0.8 to 0.99 for effectiveness of hedge.

RESULTS OF ECM:

Since the spot NIFTY Index, spot CNXIT Index are cointegrated with NIFTY Index

futures, CNXIT Index futures respectively, then according to Engle & Granger, an ECM

must exists as presented in equation (2).

Error correction equation for NIFTY and NIFTY Index futures as follows:

Error correction equation for CNXIT and CNXIT Index futures as follows:

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Table 9. And Table 10. Represents the summary of the error correction for both NIFTY

and CNXIT respectively.

By examine Table 11, we can report that the optimal hedge ratio for NIFTY is 0.492

& for CNXIT 0.988 and the error correction model for CNXIT including no lags has

good fit compared to NIFTY [i.e. CNXIT, R-sqr is 0.79 and NIFTY R-sqr is 0.674].

The error correction coefficient ụt-1 is statistically significant at level for NIFTY;

The comparison of hedge ratio’s determined by the two models for both indices are

presented in Table 11.

Results reveal that the data chosen for the test is significant. If we look at the t-test

values, they are highly significant at 5% level.

Comparison of t-test for both the models reveals that ECM model has highly

significant values.

And the white noise i.e. short term error term is also zero in both the indices. But

compared to NIFTY Index the CNXIT Index futures contract has greater significance is

error reduction. This we can observe in Table 11.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Conclusion:

In this report we have estimated optimal hedge ratio and examined the hedging

effectiveness of NIFTY and CNXIT Indices using OLS & ECM Models. And also we

have compared, which index gives maximum risk reduction, or effective hedge ratios.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

The study has carried on NIFTY Index and CNXIT Index with their respective Futures

contracts by taking the sample data over the period of 5 years for NIFTY and 3 years for

CNXIT [April 2001 to March 2006 and 28th August 2003 to March 2006 respectively].

The finding of the study suggests that in terms of risk reduction the error correction

model is the appropriate method for estimating optimal hedge ratios compared to the

conventional OLS model.

Howard & D’Antonio define hedging effectiveness as the ratio of the excess return per

unit of risk of the optimal portfolio of the spot and the futures instrument to the excess

return per unit of risk of the portfolio containing the spot asset alone.

Here, in this study we have investigated the hedging effectiveness of NIFTY & CNXIT

by looking at adjusted R-sqr, which measures the effectiveness of the hedge.

Adjusted R-sqr for CNXIT is higher compared to NIFTY in both the models. And the

error correction model results reveals higher R-sqr value for CNXIT Index compared to

the conventional model OLS.

As per the objective of the study , to examine whether the hedge ratios calculated from

two methods generate better results in terms of hedging effectiveness or not.

CNXIT Index provides larger risk reduction compared to the NIFTY in both the

methods, and as most effective hedging tool. And also hedge ratio for CNXIT Index

generated with the help of ECM is better compared to OLS.

The results show that, the CNXIT Index futures contract is an effective tool for hedging

the risk. [I.e. hedge ratio from OLS is 0.833 and from ECM is 0.988].

To minimize or to avoid the market risk, CNXIT Index futures contracts are better

instruments as compared to the NIFTY Index futures contracts.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Table: 1

5% Critical Value -1.9408

10% Critical Value -1.6163

*MacKinnon critical values for rejection of hypothesis of a unit root.

Dependent Variable: D(SPOT)

Method: Least Squares

Date: 06/10/06 Time: 19:26

Sample(adjusted): 1/08/2001 12/12/2005

Included observations: 258 after adjusting endpoints

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

SPOT(-1) -0.920747 0.060693 -15.17069 0.0000

R-squared 0.472371 Mean dependent var 0.000466

Adjusted R-squared 0.472371 S.D. dependent var 0.040508

S.E. of regression 0.029425 Akaike info criterion -4.210108

Sum squared resid 0.222511 Schwarz criterion -4.196337

Log likelihood 544.1039 Durbin-Watson stat 1.838292

Table:2

5% Critical Value -1.9408

10% Critical Value -1.6163

*MacKinnon critical values for rejection of hypothesis of a unit root.

Dependent Variable: D(SPOT)

Method: Least Squares

Date: 06/10/06 Time: 19:26

Sample(adjusted): 1/08/2001 12/12/2005

Included observations: 258 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

SPOT(-1) -0.920747 0.060693 -15.17069 0.0000

R-squared 0.472371 Mean dependent var 0.000466

Adjusted R-squared 0.472371 S.D. dependent var 0.040508

S.E. of regression 0.029425 Akaike info criterion -4.210108

Sum squared resid 0.222511 Schwarz criterion -4.196337

Log likelihood 544.1039 Durbin-Watson stat 1.838292

Table: 3

5% Critical Value -1.9423

10% Critical Value -1.6170

*MacKinnon critical values for rejection of hypothesis of a unit root.

Dependent Variable: D(SPOT)

Method: Least Squares

Date: 06/10/06 Time: 19:25

Sample(adjusted): 1/08/2003 7/20/2005

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Variable Coefficient Std. Error t-Statistic Prob.

SPOT(-1) -1.001180 0.083844 -11.94102 0.0000

R-squared 0.519210 Mean dependent var -0.000533

Adjusted R-squared 0.519210 S.D. dependent var 0.044522

S.E. of regression 0.030871 Akaike info criterion -4.110507

Sum squared resid 0.125799 Schwarz criterion -4.088775

Log likelihood 274.3487 Durbin-Watson stat 1.940398

Table: 4

5% Critical Value -1.9423

10% Critical Value -1.6170

*MacKinnon critical values for rejection of hypothesis of a unit root.

Dependent Variable: D(FUTURES)

Method: Least Squares

Date: 06/10/06 Time: 19:24

Sample(adjusted): 1/08/2003 7/20/2005

Included observations: 133 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

FUTURES(-1) -0.978766 0.083423 -11.73263 0.0000

R-squared 0.510382 Mean dependent var -0.000632

Adjusted R-squared 0.510382 S.D. dependent var 0.043697

S.E. of regression 0.030576 Akaike info criterion -4.129692

Sum squared resid 0.123408 Schwarz criterion -4.107960

Log likelihood 275.6245 Durbin-Watson stat 1.952549

Table: 5

5% Critical Value -1.9408

10% Critical Value -1.6163

*MacKinnon critical values for rejection of hypothesis of a unit root.

Dependent Variable: D(RESIDUALS)

Method: Least Squares

Date: 06/10/06 Time: 19:37

Sample(adjusted): 1/08/2001 12/19/2005

Included observations: 259 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

RESIDUALS(-1) -0.902002 0.062673 -14.39225 0.0000

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Adjusted R-squared 0.445282 S.D. dependent var 54.24563

S.E. of regression 40.40181 Akaike info criterion 10.23948

Sum squared resid 421134.9 Schwarz criterion 10.25321

Log likelihood -1325.013 Durbin-Watson stat 1.971213

Table: 6

5% Critical Value -2.8830

10% Critical Value -2.5781

*MacKinnon critical values for rejection of hypothesis of a unit root.

Dependent Variable: D(RESIDUALS)

Method: Least Squares

Date: 06/10/06 Time: 19:42

Sample(adjusted): 1/08/2003 7/27/2005

Included observations: 134 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

RESIDUALS(-1) -0.827192 0.086317 -9.583220 0.0000

C -0.352822 2.946443 -0.119745 0.9049

R-squared 0.410288 Mean dependent var 0.394552

Adjusted R-squared 0.405821 S.D. dependent var 44.23229

S.E. of regression 34.09559 Akaike info criterion 9.911026

Sum squared resid 153451.2 Schwarz criterion 9.954277

Log likelihood -662.0387 F-statistic 91.83810

Durbin-Watson stat 2.055444 Prob(F-statistic) 0.000000

Table: 7

(NIFTY and NIFTY INDEX FUTURES)

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EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

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Table: 8

(CNXIT and CNXIT INDEX FUTURES)

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Table: 9

(NIFTY and NIFTY INDEX FUTURES)

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EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Table: 10

(CNXIT and CNXIT INDEX FUTURES)

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----------------------------------------------------------------------------------------------------------------------------------------------------------------

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Table: 11

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NIFTY CNXIT

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OLS ECM OLS ECM

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

------------------------------------------------------------------------------------------------------------

This study is focused only on two indices i.e. NIFYT and CNXIT. We have tested

hedge ratios by using 2 models i.e. OLS and ECM, however, further study can be

possible for testing the hedge ratios and it effectiveness with different models like

BGARCH, GARCH, VECM etc.

Glossary:

1. Basis Risk: The risk to a future investor of the basis widening or narrowing.

Relationship between the cash price of a good and the future prices of that good.

2. Cointegration: refers to co-movements in asset prices, not co-movements in

returns.

3. Hedge Ratio: The minimum number of units of a hedging instrument needed to

be held in order to minimize the overall portfolio, which is a combination of a

cash position and an hedge position.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

unequal variance in returns .

5. Minimum Variance Hedge Ratio: refers as the proportion of the futures to the

cash position that minimizes the net price change risk. It indicates the number of

futures or options need to be bought or sold in order to reduce the variability of

the total hedged position to the maximum possible extent.

6. Near month contract: it is a type of futures contract likely to be matured within

a month, which is nearby in time.

7. Optimum Hedge: the hedge at which the utility of the hedger is maximized.

REFERENCES:

1. Working, H (1953), Futures trading and hedging: American Economic Review,

Vol. 43 , pg. 314-343.

2. Morkowitz, H.M. (1959), Portfolio selection: efficient diversification of

investments, JOHN Wiley and Sons, Inc., New York.

3. Stein, J.L. (1961), The simultaneous determination of spot and futures prices:

American Economic Review, Vol. 51, pg. 1012-1025.

4. Working H. (1962), New concepts concerning futures markets and prices:

American Economic Review, Vol. 52, pg. 431-459.

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

Journal of Finance, Vol.34, pg.157-170.

6. Howard,C, and D’Antonio, L. (1984), A risk-return measure of hedging

effectiveness,Journal of Financial and Quantitative Analysis, Vol.19 pg.101 -111.

7. Figlewski, S. (1984), Hedging performance and basis risk in stock index futures,

Journal of finance, Vol 39. pg. 657-669.

8. Lindahl, M. (1991), Risk-return hedging effectiveness measure for stock index

futures, Journal of futures markets, Vol. 11 , pg. 399-409.

9. Hsin, C, W., Kou, J, . and Lee, C.W. (1994), Anew measure to compare the

hedging effectiveness of foreign currency futures versus options, Journal of

futures markets, Vol. 14, pg. 685-707.

10. Park, T.H. and Switzer, L.N. (1995), Time-varying distributions and the optimal

hedge ratios for stock index futures, Applied financial economics,

Vol.5, pg.131-137.

11. Pennings, J.M.E., and Meulenberg, M.T.G. (1997), Hedging efficiency: a futures

exchange management approach, Journal of Futures Markets, Vol.17, pg.599-615.

12. Kavussanos, M.G., and Nomikos, N.K. (2000), Constant Vs. Time-varying hedge

ratios and hedging efficiency in the BIFFEX market, Transporatation research

Part E, Vol.36 pg. 229-248.

13. Chou, W.L. Denis, K.K.F. and Lee C.F (1996), Hedging with the Nikkei index

futures: the conventional model versus the error correction model, quarterly

Review of Economics and finance Vol.36, pg.495-505.

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