31583767

The European Journal of Finance,
Vol. 14, No. 3, April 2008, 243–270
Hedging effectiveness of the Athens stock index futures contracts
Manolis G. Kavussanosa∗ and Ilias D. Visvikisb

a Athens University of Economics and Business, Athens, Greece; b ALBA Graduate Business School, Vouliagmeni,
Athens, Greece
This paper examines the hedging effectiveness of the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 stock
index futures contracts in the relatively new and fairly unresearched futures market of Greece. Both
in-sample and out-of-sample hedging performances using weekly and daily data are examined, consid-
ering both constant and time-varying hedge ratios. Results indicate that time-varying hedging strategies
provide incremental risk-reduction benefits in-sample, but under-perform simple constant hedging strate-
gies out-of-sample. Moreover, futures contracts serve effectively their risk management role and compare
favourably with results in other international stock index futures markets. Estimation of investor utility
functions and corresponding optimal utility maximising hedge ratios yields similar results, in terms of
model selection. For the FTSE/ATHEX Mid-40 contracts we identify the existence of speculative com-
ponents, which lead to utility-maximising hedge ratios, that are different to the minimum variance hedge
ratio solutions.
Keywords: hedging effectiveness; futures markets; constant and time-varying hedge ratios; utility
functions; VECM-GARCH-X
1. Introduction
One of the most important functions of derivatives futures contracts is the ability they offer to
investors to hedge their risks from a long or a short position that they have in an ‘underlying’
commodity. Thus, a position in a futures contract is taken, which is opposite to that in the cash
market. An important issue, in this process of hedging risks, is the calculation of the correct number
of futures contracts to use for each cash position held. The solution to this problem depends on a
number of parameters, and can make a big difference for investors’ hedging effectiveness results.
These parameters include: the choice of data frequency and thus the investment rebalancing
horizon of the investor; the determination of optimal hedged portfolio selection criteria; his level
of risk aversion; risks and returns emanating from hedged portfolios; the models that are used to
estimate empirically the optimal hedges; and whether in-sample or out-of-sample horizons are
considered as relevant for the investor. This paper presents a framework that can be utilised to
answer these important issues for investors who wish to engage in derivatives markets. Often the
issues come down to selecting a particular policy from a number of alternatives and this paper
shows, through an empirical application, that results can be different according to the choice made.
The index futures contracts traded in the under-researched derivatives market of Greece are
utilised for the investigation. More specifically, the stock index futures FTSE/ATHEX-20 and the
less liquid FTSE/ATHEX Mid-40 contracts are examined by estimating hedge ratios, computed
∗ Corresponding author. Email: mkavus@aueb.gr

ISSN 1351-847X print/ISSN 1466-4364 online
© 2008 Taylor & Francis
DOI: 10.1080/13518470801890701
http://www.informaworld.com
244 M.G. Kavussanos and I.D. Visvikis
from several model specifications, in an effort to identify the hedging models that generate:
(i) the highest price risk reduction and (ii) the maximum utility increase for hedgers involved
in these markets. In answering the latter question (i.e. utility maximising hedges), most papers
assume that the futures rate follows a martingale – i.e. that expected futures prices for next period
are equal to today’s futures prices; E(F1 ) = F0 and resort back to answering the former part of
the question – that is, they estimate hedge ratios that achieve the highest reduction in portfolio
volatility. In this paper, this assumption is removed, and we let the data determine the empirical
validity of this question. This is important when there are suspicions that markets may not work
perfectly efficiently.
The operation of the organised derivatives market in Greece rests with the Athens Derivatives
Exchange (ADEX), which was founded in April 1998. The first stock index futures contract of
ADEX was the FTSE/ATHEX-20, which was introduced in August 1999, with the underlying
asset being the FTSE/ATHEX-20 stock index, which consists of the 20 highest capitalisation
stocks listed in the Athens Exchange (ATHEX). The FTSE/ATHEX Mid-40 index futures was
created, a few months later, in January 2000, and is based on 40 medium capitalisation stocks
listed in the ATHEX.1
The study is also of great importance for market participants in the derivatives market of the
ATHEX, who need to cover their risk exposure from holding portfolios of stocks in ATHEX. The
introduction of a derivatives exchange in a capital market is considered beneficial as derivatives
can complete the market, improve efficiency, transfer risk and discover prices, among others
(see, for instance, Kavussanos, Visvikis, and Alexakis 2008). The ATHEX is included in the
Morgan Stanley International Index (MSCI), as it constitutes an important market for international
investors who wish to invest in world markets. ATHEX has been upgraded from a developing
market to a mature are, and the Euro has replaced the Greek drachma as the national currency
since 2001. According to ADEX (as of 2005), the developing Greek derivatives market, despite
operating only for a few years, is already in the seventh place among European derivatives markets,
in terms of value of daily transactions (¤50–100 million ¤ in 2005), following the established
derivatives markets of Germany, UK, Italy, Euronext, Spain and Sweden. The international investor
participation has increased from 23.9% in December 2001 to 42.1% in May 2006 and the net capital
inflows from international investors in 2005 was ¤5.2 billion. The strategic planning of ADEX
includes collaboration with East Europe (Romania, Bulgaria and Slovakia) and Mediterranean
(Israel, Egypt and Cyprus) capital markets in the design and launch of indices and new derivatives
products.
Some ‘special properties’that differentiate the Greek capital market from other well-established
markets are the following: (i) the ownership structure in ATHEX is different to that of other
more mature markets, such as those of the US and the UK. In Greece, the structure is family-
owned, concentrated in block-holders, whereas in other markets the structure is diffused; (ii) the
privatisation of the public sector entities that started in early 2000 continues today. The ATHEX
is a fully privatised group aiming at value maximisation; (iii) several reforms have taken place,
in adopting the EU regulatory framework; (iv) although liquidity has increased lately, for several
listed companies, the market is thin; and (v) even though the Greek market is characterised as
mature since 2001, some emerging market characteristics may still remain. Thus, according to
Bakaert and Harvey (1997), emerging market returns are characterised by low liquidity, thin
trading, higher sample averages, low correlations with developed market returns, non-normality,
better predictability, higher volatility and short samples. In addition, market imperfections, high
transaction and insurance costs, less informed rational traders and investment constraints may also
affect the risks and returns involved. Therefore, it is deemed important to empirically examine
The European Journal of Finance 245
the effectiveness of risk management strategies, using derivatives contracts for such markets. For
the Greek derivatives market, it is often argued that it is characterised by the absence of highly
specialised traders, by the absence of a respective large number of foreign derivatives traders (for
the period examined in this study) and by the value of trading in derivatives during a normal day in
ADEX representing a fraction of that traded in the underlying cash market. These issues, among
others, make the Greek market interesting to investigate.
This study contributes to the existing literature in a number of ways. First, it is important to know
whether hedging effectiveness results coming from newly established derivatives markets are in
accordance with corresponding results from well-established derivatives markets. The latter have
been examined considerably in the literature, with results indicating that hedging effectiveness
in stock index futures ranges from 80% to 99% (Yau 1993; Lee 1994; Park and Switzer 1995,
among others).
Second, the criteria used for model selection consider both risk-averse investors, who wish to
minimise their risks (by considering their variance-return position) through hedging, and investors
that aim to maximise expected utility, by taking into account returns, risks and preferences towards
risk (the degree of risk aversion).2 The latter method is practical and relevant for investors who are
not entirely risk-averse, but are willing to undertake some risks in order to increase their returns
and their utility from their investments, as a consequence. Moreover, taking into account the degree
of the investor’s risk aversion may result in different optimal model selection in comparison to
the mean–variance maximisation criterion. Raju (2005) investigates optimal hedging solutions
for Ecuador oil and argues that the optimal hedging strategy is not significantly different for high
levels of risk aversion.
Third, different model specifications are estimated and compared so as to select the model,
which takes into account the properties of cash and futures prices. Thus, the hedging effective-
ness of dynamic hedge ratios is in contrast with the effectiveness of constant hedge ratios. The
assumption by many models of constant hedge ratios is considered restrictive and is in contrast
with the empirical evidence in a number of markets (e.g. Kroner and Sultan 1993; Bera, Garcia,
and Roh 1997, among others), which indicates that the issue of whether hedge ratios are constant
or time-varying (as a consequence of the time-varying distributions of returns and futures prices)
is an empirical one. Moreover, the selection of a particular model among a number of alternatives,
to estimate optimal hedge ratios, addresses (partly) the concerns raised by Simons (1997), among
others, regarding the model risk problem, which arises when results rely on a particular potentially
misspecified model.
Fourth, economic analysis suggests that the prices of the cash asset and the futures contract are
jointly (simultaneously) determined (Stein 1961). Consequently, the estimation of hedge ratios
by univariate models may be subject to simultaneity bias; as a consequence, the estimated hedge
ratios may not be optimal. Furthermore, hedge ratios estimated by univariate models are potentially
misspecified because they ignore the existence of a long-run cointegrating relationship between
cash and derivatives prices (Engle and Granger 1987) and fail to capture the short-run dynamics
by excluding relevant lagged variables; this results in smaller-than-optimal hedge ratios (Kroner
and Sultan 1993; Ghosh 1993).
Fifth, the squared lagged disequilibrium error term between cash and futures prices is allowed
to enter the specification of the variances of the estimated models, thus allowing disequilibrium
effects to influence risk levels in the two markets.
Sixth, the distribution of the data used is determined empirically; in line with the evidence in
other (emerging or newly matured) markets, the data set for the Greek market follows a Student-t
distribution with the degrees of freedom determined empirically during estimation.
Seventh, different data frequencies (weekly and daily) are employed, which allow us to exam-
ine the question of optimal frequency rebalancing in the presence of transaction costs. In order
to answer this question, the benefits from frequent portfolio rebalancing are compared to the
higher transaction costs involved. This is more pragmatic than simply taking an ad hoc frequency
and estimating hedge ratios. It also answers the important question of optimal rebalancing and
investment horizons of hedged portfolios.
Eight, in-sample and out-of sample tests are employed to assess the hedging effectiveness
of futures contracts. In-sample tests are based mainly on historical information, when it is more
relevant for practitioners to examine the out-of-sample forecasting performance of hedging ratios.
This paper extends the extant literature by examining the hedging performance both in-sample
and out-of-sample, for a number of alternative model specifications, identifying the appropriate
model in each case. The empirical models selected turn out to be different between the in-sample
and out-of-sample periods and justify our approach.
Finally, these contributions are over and above what we have already seen published in the
literature regarding the ADEX market (see, for instance, Floros and Vougas 2004; Kavussanos
and Visvikis 2005).
The remainder of this paper is organised as follows. Section 2 presents the investor’s mean–
variance operating framework and the empirical models that may be used to determine alternative
optimal hedge ratios. Section 3 discusses the properties of the data. Section 4 presents the empirical
results and evaluates the hedging effectiveness of the proposed strategies. Finally, Section 5
concludes the paper.
2. Optimal hedge ratio models

Consider a hedger with a long (short) position in the cash market. He takes a short (long) position
in the futures market of magnitude (as a percentage) γt to offset the cash position. That is, the
gains in one market will offset the losses in the other. Equation (1) shows the hedger’s cash-futures
portfolio return, whereas Equation (2) shows the variance of this portfolio return:
RH,t = St − γt Ft (1)

2
σH,t = Var t (St − γt Ft ) = Var t (St ) + γt2 Var t (Ft ) − 2γt Covt (St , Ft ) (2)
where St = St − St−1 is the logarithmic change in the cash price between time periods t − 1
and t; Ft = Ft − Ft−1 is the logarithmic change in the futures price between t − 1 and t; RH,t
2
is the conditional return of the hedged portfolio; σH,t is the conditional variance of the return
2
of this portfolio; σS,t ≡ Var t (St ) and σF,t
2
≡ Var t (Ft ) are the conditional variances of the
returns on cash and futures positions, respectively; σS,F,t ≡ Covt (St , Ft ) is the conditional
covariance of returns between the cash and futures positions; and γt is the hedge ratio – the futures
contracts traded as a percentage of the cash position – at time t. This hedge ratio may be constant
over the period of the hedge or time-varying as in Equations (1) and (2). When γt = 0 the cash
position remains unhedged, when γt = 1 the futures position is equal in magnitude (and opposite)
to the cash position – this is known as ‘naïve hedge’, and provides a ‘perfect’ hedge when cash
and futures prices move by the same amount; that is, when they are perfectly correlated and the
volatilities in the two markets are equal. Usually, cash and futures prices do not move perfectly
together. As a consequence, hedgers select γt = 1, in order to improve their hedging effectiveness,
in what may be called a ‘conditional hedge’. Moreover, if the distributions of cash and futures
prices are time-varying, hedgers improve further the effectiveness of their hedges by allowing γt
to be time-varying.
It is often forgotten that hedging involves an opportunity cost in terms of foregone returns. It is
more pragmatic then to compare this cost with the benefit emanating from the reduction in risk.
The degree of risk aversion of the hedger plays an important role in resolving this issue. To this
effect, assume that the risk-averse investor aims to maximise the expected utility (Et U (RH,t+1 ))
from his portfolio, given the information set available at time period t. That is, he aims to maximise
the expected return from his hedged portfolio of cash and futures positions subject to the expected
risks (variances) that he faces, and a certain level of risk aversion that describes his preferences
regarding risks. He derives utility from higher returns, but has disutility from higher variances
(risks) and vice versa, where the returns and variances of his portfolio determine the framework
under which he operates. Consider, thus, the following mean–variance expected utility function:
Et U (RH,t+1 ) = Et (RH,t+1 ) − kVar t (RH,t+1 ) (3)
where k is the risk-aversion coefficient, measuring the degree of risk aversion (k > 0) of the
individual investor; where higher (lower) values of k imply higher (lower) levels of risk aversion.
The model given here assumes that the hedger has a quadratic utility function or that returns are
normally distributed in a Markowitz (1959) framework – (see also Kroll, Levy, and Markowitz
1984 for quadratic utility functions).
Optimising Equation (3) with respect to γt yields the following utility maximising hedge ratio
(UMHR, γt∗∗ ):

∗∗ Covt (St+1 , Ft+1 ) Et (Ft+1 ) − Ft ∗ −(Ft − Et (Ft+1 ))
γt = − = γt +
Var t (Ft+1 ) 2kVar t (Ft+1 ) 2kVar t (Ft+1 )

−Biast+1
= γt∗ + (4)
2kVar t (Ft+1 )
where γt∗ is the minimum variance hedge ratio (MVHR), that is, the following hedge ratio that
2
minimises, with respect to γt , the variance σH,t in Equation (2):

∗ Covt (St , Ft ) σS,t
γt = = ρSF,t (5)
Var t (Ft ) σF,t
where Covt (St , Ft ) and ρSF,t denote the conditional covariance and correlation coefficient,
respectively, between cash and futures price returns, while Biast+1 = Et (Ft+1 ) − Ft denotes the
bias in the futures market between periods t and t + 1. γt∗ is the MVHR, and is the optimal hedge
ratio for investors who are completely risk averse; that is, who are not concerned about returns,
but simply wish to minimise the variance of returns of their hedged portfolios, as described in
Equation (2). In other words, in their utility function of Equation (3), the term Et (RH,t+1 ) is not
relevant.
Thus, the UMHR (γt∗∗ ) equals the risk-minimising MVHR (γt∗ ), augmented by an element
which accounts for the existence of speculative components in the hedge. If futures prices at time
period t (Ft ) are unbiased predictors of expected futures prices for time period t + 1(Et (Ft+1 )),
technically if futures returns follow a martingale, and for a finite k, then γt∗∗ = γt∗ ; that is, in
this case, the hedge ratio that generates the minimum portfolio variance is also the hedge ratio
that maximises the investor’s utility. This would be the case in well-functioning efficient futures
markets. There may be markets though where futures prices are biased (Ft = Et (Ft+1 )); if not
at all times, for at least some periods of time. Then the UMHR (γt∗∗ ) contains both hedging and
speculative components which investors may wish to utilise to increase their utilities. Moreover,
one can distinguish these two components empirically; the first component in Equation (4) repre-
sents the MVHR, whereas the second represents the speculative component. Thus, in case futures
prices are biased, there is a speculative motivation to trade so as to take advantage of the bias in
the futures market (Lien and Tse 2002). The speculative component essentially captures the effect
of short hedging (short in futures – long in cash) on expected returns. If the expected futures price
is less (more) than the current futures price, the hedger benefits from selling (buying) futures
contracts. Finally, it should be noted that the UMHR also equals the MVHR for investors who are
completely risk averse (κ → ∞). Thus, with infinite risk aversion, the UMHR is independent of
the bias in futures prices and is simply equal to MVHR.
2.1 Empirical models for the estimation of optimal hedge ratios

The question addressed next is how to estimate the UMHR and the MVHR empirically. Starting
with the conventional or constant UMHR (γt∗∗ ), this can be estimated (where appropriate) from
Equation (4), with the Biast+1 and Vart (Ft+1 ) estimated as constants over the sample period.
The conventional (constant) MVHR (γt∗ ) can be estimated as the slope coefficient (γ ∗ ) in the
following ordinary least-squares (OLS) regression (see, for instance, Ederington 1979):
St = h0 + γ ∗ Ft + εt , εt ∼ iid(0, σ 2 ) (6)
Two potential problems exist with this specification. First, if cash and futures prices are coin-
tegrated, an error-correction term (ECT) should be included in Equation (6); if the ECT is not
included, then Equation (6) suffers from omitted variables bias, resulting in downward biased
values of the coefficient γ ∗ (Kroner and Sultan 1993). Second, if the distributions (and their
moments) of cash and futures prices are time-varying, so will γ ∗ in Equation (6). Once more, the
effectiveness of the hedges may be improved upon by examining this issue empirically.
To account for the first problem, of the potential omission of the ECT from Equation (6), the
bivariate vector-error correction model (VECM) of Equation (7) is also used to estimate γ ∗ :

p−1
Xt = i Xt−i + Xt−1 + εt , εt |
1 ∼ distr(0, H ) (7)
i=1
where Xt is a (2 × 1) vector (St , Ft ) of non-stationary I (1) logarithmic cash and futures prices,
respectively; denotes the first difference operator; and εt is a (2 × 1) vector of regression
equation error terms (εS,t , εF,t ) , which are serially independent and follow an as-yet-unspecified
conditional (on the available information set,
t−1 ) bivariate distribution with mean zero and
variance–covariance matrix H . The VECM specification contains information on both the short-
and long-run adjustments to changes in Xt , via the estimated parameters in i and , respectively.
Johansen (1988, 1991) tests are used first to determine whether the series stand in a long-run
relationship between them, that is, to test whether they are cointegrated. Kavussanos, Visvikis,
and Alexakis (2008) show that this is the case for the pairs ATHEX-20–FTSE/ATHEX-20 and
ATHEX Mid-40–FTSE/ATHEX Mid-40 cash and futures prices in the Greek markets. If such
a long-run relationship is verified, then the VECM model of Equation (6) should be estimated,
and includes the lagged ECT, Xt−1 ≡ (St−1 − β1 − β2 Ft−1 ), as suggested by Engle and Granger
(1987). In this case, constant VECM estimates of γ ∗ (and γ ∗∗ ) can be obtained as in the following
ratio of the covariance of the error terms of the cash and futures equations (Cov(εS,t , εF,t ) = σSF )
over the variance of the error term of the futures equation (Var(εF,t ) = σF2 ) from the bivariate
VECM of Equation (7):
Cov(εS,t , εF,t ) σSF
γ∗ = = 2 (8)
Var(εF,t ) σF
Kroner and Sultan (1993) show how to resolve the second issue arising from estimating constant
MVHRs (and UMHRs) from Equation (7), when the conditional distributions of cash and futures
prices are time-varying. Thus, in the VECM of Equation (7), the variance–covariance matrix (H )
of the bivariate regression error term is allowed to become time-varying (Ht ) in a generalised
autoregressive conditional heteroskedasticity (GARCH) error structure (Bollerslev 1987), such
as that of Equation (9). In this bivariate VECM-GARCH model, daily cash and futures prices
react to the same information, and hence have non-zero covariances conditional on the available
information set (
t−1 ). Moreover, in this paper we introduce a lagged squared ECT [(Xt−1 )2 ]
in the specification of the variance, in what we call a VECM-GARCH-X model. Following Lee
(1994), the inclusion of this lagged squared ECT of the cointegrated cash and futures prices can
capture the potential relationship between disequilibrium (measured by the ECT) and uncertainty
(measured by the conditional variance). This is specified using the BEKK (Baba, Engle, Kraft,
Kroner) augmented positive definite parameterisation (for more details, see Baba et al. 1995)3 :
Ht = A A + B Ht−1 B + C εt−1 εt−1

C + G (Xt−1 )2 G (9)
2
2
σS,t σSF,t a 0 a11 0 b 0 σS,t−1 σSF,t−1 b11 0
2 = 11 + 11 2
σSF,t σF,t a21 a22 a21 a22 0 b22 σSF,t−1 σF,t−1 0 b22

c11 0 ε1,t−1 ε1,t−1 c11 0 g11 2 g11
+ + (Xt−1 )
0 c22 ε2,t−1 ε2,t−1 0 c22 g22 g22
where A is a (2 × 2) lower triangular matrix of coefficients, B and C are (2 × 2) diagonal coeffi-
2
cient matrices, with bkk + ckk
2
< 1, k = 1, 2 for stationarity and G is a (1 × 2) vector of coefficients
of the lagged squared ECT [(Xt−1 )2 ]. Matrices B and C are restricted to be diagonal because
this results in a more parsimonious representation of the conditional variance. In this representa-
tion, the conditional variances are a function of their own lagged values (persistence term, Ht−1 ),
2
their own lagged squared error terms (lagged shocks, εt−1 ) and a lagged squared ECT parame-
ter, (Xt−1 ) = (St−1 − β1 − β2 Ft−1 ) , whereas the conditional covariance is a function of lagged
2 2
covariances and lagged cross-products of the error terms.4

The most parsimonious specification for each model is estimated by excluding insignificant
variables from the mean and the variance of the estimated models. The Broyden, Fletcher,
Goldfarb, and Shanno (BFGS) algorithm (Shanno and Phua 1980) is used for estimation. Fol-
lowing Bollerslev (1987), in order to take into account the possibility of non-normality during
estimation, the conditional Student-t distribution is used as the density function of the bivariate
error term, where the degrees of freedom are allowed to be determined empirically by the data.
Following estimation of the VECM-GARCH-X or VECM-GARCH models, time-varying covari-
ances and biases (where appropriate) are used to calculate γt∗ and γt∗∗ as in Equations (8) and (4),
respectively.
2.2 Hedge ratios and hedging effectiveness measures

Following estimation of OLS, VECM, VECM-GARCH and VECM-GARCH-X models,
corresponding constant and time-varying MVHRs and UMHRs are computed. For each market,
we consider five different hedge ratios: time-varying hedge ratios computed from VECM-GARCH
and VECM-GARCH-X specifications; constant hedge ratios generated from VECM with constant
variances, estimated as (seemingly unrelated regressions SUR) systems (Zellner 1962); constant
OLS hedge ratios from Equation (6); and naïve hedges, by taking futures positions, which are
same in size as the cash positions (i.e. setting γ ∗ = 1). Comparison between the effectiveness
of optimal hedge ratios, computed from different models, is made by constructing portfolios
implied by the computed ratios each week (day, for daily data) and then comparing the variances
or the expected utilities of the returns of these constructed portfolios. Two measures of hedging
effectiveness are considered.
The first measure is the variance reduction (VR) statistic of Equation (10), which compares
the variance of the returns of the hedged portfolios (Var(RH,t )), to the variance of the unhedged
positions, i.e. to Var(St ):
Var(St ) − Var(RH,t )
VR = × 100 (10)
Var(St )
The greater the reduction in the unhedged variance, the better the hedging effectiveness. That is,
the higher the value of VR in Equation (10), the greater is the hedging effectiveness.
Notice that for the OLS the degree of VR of the hedged portfolio, achieved through hedging,
is provided by the coefficient of determination (R 2 ) of the regression, since this represents the
proportion of the variability (risk) in the cash market that is explained (eliminated) through hedging
(the variability of the futures position); the higher the R 2 , the greater is the effectiveness of the
hedge.
We introduce a second measure of hedging effectiveness, which considers the economic benefits
from hedging, as obtained from the hedger’s utility function of Equation (3) and takes hedgers’
preferences into account. Consider the following utility increasing (UI) statistic:
UI = Et U (RH,t ) − Et U (St ) (11)
It compares the expected utility increase/decrease for investors, by comparing the expected utility
of the hedged with that of the unhedged portfolios. The greater the increase in the utility of a
strategy, in relation to the unhedged position, the better the hedging effectiveness.
3. Data
The data sets used consist of weekly (250 Wednesday prices) and daily (1186 prices) cash and
futures prices of the FTSE/ATHEX-20 market from 1 September 1999 to 7 June 2004, and weekly
(228 Wednesday prices) and daily (1082 prices) cash and futures prices of the FTSE/ATHEX
Mid-40 market from 1 February 2000 to 7 June 2004. When a holiday occurs on Wednesday,
Tuesday’s observation is used in its place. Futures prices are always those of the nearby contract
because it is the most liquid and active contract. To avoid thin markets and expiration effects
(when futures contracts approach their settlement days, their trading volume decreases sharply),
we rollover to the next nearest contract one week before the nearby contract expires. Cash price
data are obtained from the ATHEX, whereas futures price data are from the ADEX. For analysis,
all price series are transformed into natural logarithms.
Most studies in the economic literature (see, for example, Kroner and Sultan 1993; Gagnon
and Lypny 1997, among others) use weekly data to calculate hedge ratios of futures contracts.
The choice seems to be justified as it implies that hedgers in the market rebalance their futures
positions at no less than a weekly basis, due to excessive transaction costs which would be
incurred if rebalancing takes place more frequently than once a week. Time-varying hedging
strategies have higher implementation costs than constant strategies, as they require frequent
updating and rebalancing of hedged portfolios. Thin trading, relatively low liquidity, high bid-ask
spreads and high transaction costs can make daily rebalancing expensive. Therefore, the choice of
rebalancing frequency, in the presence of transactions costs, is of high importance to the decision-
maker. Weekly data provide adequate number of observations (N = 250 in FTSE/ATHEX-20
and N = 228 in FTSE/ATHEX Mid-40) to allow investigation of the in- and out-of-sample
performance of GARCH-based hedge ratios. Daily data are also used and give qualitatively the
same results in terms of model specification and optimal hedge ratio selection.
Summary statistics of logarithmic first-differences of weekly and daily cash and futures prices
in the two markets are presented in Table 1. The results indicate excess kurtosis in all cases. There
is also evidence of excess skewness in all series for daily but not for weekly data. In turn, Jarque
and Bera (1980) tests indicate departures from normality for cash and futures prices. The Ljung-
Box Q(i) statistics (for i = 4, 12 and 24) (Ljung and Box 1978) on the first 4, 12 and 24 lags of
the sample autocorrelation function of the series, the Q2 (i) statistics (for i = 4, 12 and 24) of the
squared series and the ARCH(i) statistics (for i = 4, 12 and 24) (Engle 1982) indicate existence
of serial correlation, heteroskedasticity and time-varying heteroskedasticity in the returns series
of both markets.
Given the time-series nature of the data, the first step in the analysis is to determine the order of
integration of each price series using augmented Dickey–Fuller (ADF 1981) and Phillips–Perron
(PP 1988) tests. Application of the ADF and PP unit root tests on the log-levels and log-first
differences of the daily and weekly cash and futures price series indicate that all variables are
log-first difference stationary, all having a unit root on the log-level representation (not shown
due to lack of space).
4. Empirical results
Having identified that cash and futures prices are I (1) variables (integrated of order 1), Johansen
(1988) cointegration tests are used next to examine the existence of long-run relationships between
cash and futures prices in the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 markets. The results
indicate that at both frequencies (daily and weekly) the corresponding cash and futures prices in
both markets are cointegrated, and thus, stand in a long-run relationship between them.5 In order
to examine whether the exact lagged basis or an unrestricted spread should be included as an ECT
in the mean and variance equations of the VECM and VECM-GARCH-X models, the following
cointegrating vector, β Xt = (β0 St β1 β2 Ft ) is examined, testing whether β = (1, 0, −1). This
would imply that the ECT is the lagged basis; that is, that Xt−1 = St−1 − Ft−1 . For both weekly and
daily data the results, which are not shown here due to lack of space, indicate that the restrictions
are not accepted in both markets. Thus, in the ensuing analysis, the unrestricted spread is used in
the estimation of the VECM, VECM-GARCH and VECM-GARCH-X models.
4.1 Estimated models

Having determined that cash and futures prices are cointegrated and that the basis is unrestricted,
maximum-likelihood estimates of the most parsimonious VECM-GARCH and VECM-GARCH-
X models, based on weekly data, selected on the basis of LR tests, for each market, are presented in
Table 2.6 The estimates of the coefficients of the mean and variance equations are shown in panels
A and B, respectively. In the FTSE/ATHEX-20 market, a VECM-GARCH(1,1) specification is
252
Table 1. Descriptive statistics of weekly and daily logarithmic first-differences of cash and futures prices.
M.G. Kavussanos and I.D. Visvikis

ARCH ARCH ARCH ADF PP ADF PP
Mean Skew Kurt Q(4) Q(12) Q(24) Q2 (4) Q2 (12) Q2 (24) (4) (12) (24) J-B Lev Lev first differences
Panel A: FTSE/ATHEX-20 weekly cash and futures price series (09/99 to 06/04)
Cash −0.0033 0.254 1.389 959.26 2671.1 4766.8 860.80 2662.0 2888.3 1293.1 368.8 182.7 21.356 −1.855 −1.737 −11.284 −15.923
(249) [0.1892] [0.103] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] Q2 (12) [0.000] [0.000] [0.000] [0.000] (1) (5) (1) (10)
Futures −0.0032 0.191 1.049 959.94 2672.9 4760.9 863.76 2665.0 2890.1 1266.3 354.2 167.3 11.681 −1.707 −1.697 −11.711 −15.078
(249) [0.1969] [0.220] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (1) (7) (1) (7)
Panel B: FTSE/ATHEX Mid-40 Weekly Cash and Futures Price Series (02/00 to 06/04)
Cash −0.0064 −0.007 1.771 80.32 2080.1 3415.3 622.72 2066.6 2671.4 1208.2 427.3 140.7 27.556 −2.189 −2.346 −13.379 −13.311
(249) [0.0321] [0.964] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (0) (10) (0) (9)
Future −0.0066 −0.057 1.521 804.32 2053.3 3368.0 606.63 2026.7 2556.7 966.7 346.8 125.2 20.427 −2.203 −2.376 −13.585 −13.521
(249) [0.0418] [0.729] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (0) (7) (0) (6)
Panel C: FTSE/ATHEX-20 Daily Cash and Futures Price Series (09/99 to 06/04)
Cash −0.0007 0.183 3.546 4706.4 13,867 27,033 4587.0 12,961 23,951 33,947 11,043 5850.8 620.81 −1.730 −1.685 −29.789 −29.734
(1081) [0.1552] [0.010] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (0) (1) (0) (5)
Futures −0.0006 0.166 3.347 4706.6 13,874 27,044 4589.9 13,017 24,089 31,138 10,205 5240.4 552.31 −1.691 −1.653 −31.659 −31.663
(1081) [0.1824] [0.019] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (1) (3) (0) (1)
Panel D: FTSE/ATHEX Mid-40 Daily Cash and Futures Price Series (02/00 to 06/04)
Cash −0.0013 −0.203 3.192 4234.5 12,171 22,868 4030.6 10,582 17,738 41,183 13,053 5925.6 460.66 −1.991 −1.950 −27.181 −27.214
(1081) [0.0183] [0.006] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (1) (9) (0) (8)
Future −0.0014 −0.126 4.092 4226.1 12,131 22,738 3993.6 10,431 17,306 29,228 7920 3494.6 748.13 −2.060 −2.008 −30.950 −30.967
(1081) [0.0412] [0.090] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] (0) (6) (0) (7)
Data series are measured in logarithmic first differences. Numbers in parentheses below the headers Cash and Futures are number of observations. Figures in square brackets
[.] indicate exact significance levels.
√ Mean is the sample √ mean of the series. Skew and Kurt are the estimated centralised third and fourth moments of the data; their asymptotic
distributions under the null are T â3 ∼ N (0, 6) and T (â4 − 3) ∼ N (0, 24), respectively. Q(i) and Q2 (i) are the Ljung-Box (1978) Q statistics on the first i (for i = 4, 12
and 24) lags of the sample autocorrelation function of the raw series and of the squared series. ARCH(i) is the Engle (1982) test for ARCH effects (for i = 4, 12 and 24). J-B is
the Jarque and Bera (1980) test for normality. ADF is the Augmented Dickey Fuller (1981) test. The ADF regressions include an intercept term; the lag-length of the ADF test
(in parentheses) is determined by minimising the SBIC (1978). PP is the Phillips and Perron (1988) test; the truncation lag for the test is in parentheses. Lev and first differences
correspond to price series in log-levels and log-first differences, respectively. The 95% critical value for the ADF and PP tests is –2.88. The results indicate excess kurtosis and
departures from normality for the cash and futures prices in both markets. The Q(i) statistic indicate significant serial correlation, while the Q2 (i) statistic and the ARCH(i)
statistic indicate existence of heteroskedasticity in the price series in both markets. The ADF and PP tests indicate that all variables are log-first difference stationary, all having
a unit root on the log-levels representation.
Table 2. Maximum likelihood estimates of VECM-GARCH-X models. (FTSE/ATHEX-20:

1999:09-2004:06, FTSE/ATHEX Mid-40:2000:02-2004:06)
VECM-GARCH(1,1) VECM-GARCH(1,1)-X
Cash Futures Cash Futures
Coefficients FTSE/ATHEX-20 FTSE/ATHEX-20 FTSE/ATHEX-40 FTSE/ATHEX-40
Panel A: Conditional Mean Parameters

aj , j = S, F 0.263 (0.909) 0.719 (2.401) 0.488 (1.898) 0.862 (3.130)
[0.363] [0.016] [0.058] [0.002]
aj,1 , j = S, F −0.707 (−2.386) −0.525 (−1.731) 0.213 (1.801) 0.427 (1.769)
[0.017] [0.083] [0.072] [0.069]
bj,1 , j = S, F 0.712 (2.453) 0.561 (1.875) −0.38 (−1.851) −0.233 (−1.879)
[0.014] [0.061] [0.063] [0.075]
Panel B: Conditional Variance Parameters
a11 0.0270 (8.151) [0.000] 0.0015 (0.663) [0.507]
a21 0.0257 (6.166) [0.000] 0.0029 (1.243) [0.214]
a22 0.0244 (6.168) [0.000] 0.0058 (2.339) [0.019]
bkk , k = 1, 2 0.268 (1.359) 0.431 (2.514) −0.938 (−41.411) −0.922 (−30.123)
[0.174] [0.012] [0.000] [0.000]
ckk , k = 1, 2 0.332 (3.403) 0.323 (3.566) 0.188 (2.457) 0.207 (2.459)
[0.000] [0.001] [0.000] [0.014] [0.013]
gkk , k = 1, 2 − − 0.982 (5.166) 1.092 (4.559)
[0.000] [0.000]
v 5.773 (3.941) [0.000] 6.410 (3.504) [0.000]
Panel C: Diagnostic tests on standardised residuals
Log-Likelihood 1130.58 925.62
Skewness 0.127 [0.449] 0.140 [0.405] 0.177 [0.325] 0.212 [0.240]
Kurtosis 1.389 [0.000] 1.579 [0.000] 2.092 [0.000] 2.645 [0.000]
Q(12) 8.455 [0.672] 7.865 [0.725] 15.743 [0.151] 12.824 [0.305]
Q2 (12) 8.826 [0.638] 7.516 [0.756] 6.578 [0.832] 5.985 [0.874]
ARCH(12) 0.658 [0.790] 0.510 [0.907] 0.699 [0.751] 0.601 [0.839]
AIC −2233.17 −1819.23
SBIC −2185.98 −1767.53
The maximum-likelihood estimates of the preferred VECM-GARCH and VECM-GARCH-X models, selected on the basis
of LR tests, for each market are given in panels A and B for the mean and variance equations, respectively. Diagnostic
tests for the standardised residuals are in panel C. All variables are in natural logarithms. The GARCH models in both
markets are estimated using the Student-t distribution; v is the estimated degrees of freedom of the Student-t distribution.
The BFGS algorithm is used to estimate the models. Figures in parentheses (.) and in squared brackets [.] indicate
t-statistics and exact significance levels (P -values), respectively. Q(12) and Q2 (12) are the Ljung-Box (1978) tests for
12th order serial correlation and heteroskedasticity in the standardised residuals and in the squared standardised residuals,
respectively. ARCH(12) is Engle’s (1982) F test for Autoregressive Conditional Heteroskedasticity. SBIC is the Schwartz
Bayesian Information Criterion (Schwartz 1978).

p−1
p−1
St = aS,i St−i + bS,i Ft−i + aS Xt−1 + εS,t
i=1 i=1

p−1
p−1
εS, t
Ft = aF,i St−i + bF,i Ft−i + aF Xt−1 + εF,t ; εt =
∼ t − dist(0, Ht , v) (7)
εF, t t−1
i=1 i=1
Ht = A A + B Ht−1 B + C εt−1 εt−1

C + G (Xt−1 )2 G (9)
selected. In the FTSE/ATHEX Mid-40 market, a VECM-GARCH(1,1)-X model is appropriate,

where the lagged squared unrestricted ECT in the variance is found significant in both the cash
and in the futures equations.
The lagged ECT in the mean of the cash equation is insignificant in the FTSE/ATHEX-20
market, whereas it is significant only at the 10% level for the FTSE/ATHEX Mid-40 market.
Normally, one would expect negative coefficients of the ECT terms in the cash market equations;
in this case they are statistically zero or marginally positively significant. The lagged ECT term in
the mean of the futures equations is significant and positive in both markets, which is in line with
a priori expectations. The above is an indication that last week’s disequilibrium effect between
the cash and futures price series has an impact on the futures market, but not on the cash market.
Thus, in response to a positive forecast error, only the futures price series increases in value to
restore the long-run equilibrium. This may indicate a relative weakness in the cash markets, in
comparison to their futures price series counterparts, to respond to a long-run disequilibrium in the
cash–futures markets relationship (see also Kavussanos, Visvikis, and Alexakis 2008 for further
evidence on this).
In relation to the short-run dynamics, it is observed that the lagged cash price change (St−i )
coefficients are negative, whereas the lagged futures price change (Ft−i ) coefficients are pos-
itive in the FTSE/ATHEX-20 cash and futures markets, but the situation is the opposite in the
FTSE/ATHEX Mid-40 markets. It seems that in the relatively more liquid FTSE/ATHEX-20
market, last week’s information from the futures market influences positively the current cash and
futures returns, whereas in the illiquid FTSE/ATHEX Mid-40 market last week’s information
has the opposite effect. In contrast, previous (last) week’s information from the cash markets
influences negatively the current returns in the cash and futures FTSE/ATHEX-20 markets, and
negatively the current returns in the cash and futures FTSE/ATHEX Mid-40 markets. In the
FTSE/ATHEX-20 cash market equation, the persistence of lagged cash and futures price changes
in the mean is zero as the coefficients −0.707 and +0.712, effectively add up to 0. This persistence
in the corresponding futures equation is also minimal, standing at +0.036. In the FTSE/ATHEX
Mid-40 cash market equation the persistence of lagged cash and futures price changes in the
mean is −0.17, whereas this persistence in the corresponding futures equation stands at +0.19,
both being non-zero. These results for the FTSE/ATHEX Mid-40 market make sense, because
this market displays much lower liquidity in comparison to the FTSE/ATHEX-20 market, with
illiquidity manifesting itself in higher persistence effects.7
In the variance equations, the coefficients of the lagged squared error terms (ckk ) are positive in
both the FTSE/ATHEX-20 and in the FTSE/ATHEX Mid-40 markets. However, the coefficients
of the lagged variance terms (bkk ) are positive in the FTSE/ATHEX-20 market but negative in the
FTSE/ATHEX Mid-40 market. The variance term coefficient (bkk ) can be thought of as reflecting
the impact of old news. It is picking up the impact of volatility changes relating to the period prior
to the last one, and thus, to volatility news which arrived the period before last period. The negative
sign (and the high t-statistics) indicates that the volatility of the FTSE/ATHEX Mid-40 market
is more susceptible to negative old news, and vice versa for the positive coefficient observed in
the FTSE/ATHEX-20 market; it has to be noted that for the latter market it is only in the futures
and not in the cash market that this coefficient is significant.
From the above it can be noticed that the selected models for the two markets (a VECM-GARCH
for the FTSE/ATHEX-20 and a VECM-GARCH-X for the FTSE/ATHEX Mid-40 market) yield
qualitatively different results. Their differences may be due to: the different model specifications
(e.g. inclusion of a lagged squared ECT in the variance in the VECM-GARCH-X model), the
different compositions of the underlying stock indices of the futures contracts and the different
estimation periods. Moreover, the significantly lower level of trading volume and liquidity in the
FTSE/ATHEX Mid-40 futures market, when compared with the more liquid FTSE/ATHEX-20
futures market, may be another reason for the observed differences between the two markets in
both the mean and variance equations results.
Returns follow conditional t-distributions with 5.773 and 6.410 degrees of freedom, respec-
tively, for the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 markets. Panel C of Table 2 reports
the diagnostic tests for the standardised residuals (εt / ĥt), including Ljung-Box (1978) statistics
for 12th-order serial correlation in levels and squares of the standardised residuals. They indi-
cate the absence of significant serial correlation, heteroskedasticity and ARCH effects. Moreover,
the test statistics for asymmetry (sign bias, negative size bias, positive size bias, joint sign and
size bias) developed by Engle and Ng (1993), but not shown here due to lack of space, indicate
the absence of any size or sign biases in the standardised residuals of the equations. Thus, the
estimated models are well specified and fit the data very well.
4.2 Hedging effectiveness results

4.2.1 In-sample hedge ratios
Having estimated OLS, VECM, VECM-GARCH and VECM-GARCH-X models, the correspond-
ing optimal constant and time-varying MVHRs (Equation (5)) and UMHRs (Equation (4)), optimal
2
hedged portfolio returns (RH,t ) (Equation (1)), variances (σH,t ) (Equation (2)), and expected util-
ities (Equation (3)) as well as VR (Equation (10)) and utility increases (UI) (Equation (11)) are
presented in Table 3, assuming a risk-aversion parameter of k = 3. The latter is in line with most
empirical studies in the literature.8 However, this assumption is relaxed later and the risk-aversion
coefficient is allowed to take several different values. Second, if futures prices are unbiased, that
is, if they follow a pure martingale process (i.e. if Et (Ft+1 ) = Ft ), the MVHR equals the UMHR,
and there is no speculative demand component. The existence of such a speculative component in
a hedge can only be verified empirically. Panels A and B of the table show the in-sample estimates
for daily and weekly frequencies, respectively, whereas Panels C and D present the corresponding
out-of-sample estimates.
Results for the FTSE/ATHEX-20 market, based on both weekly and daily data, indicate that
time-varying hedge ratios, estimated from the VECM-GARCH model, outperform the constant
hedge ratios, based on the VR criterion of Equation (10). For the FTSE/ATHEX Mid-40 market the
results are almost similar, with time-varying hedge ratios, computed from the VECM-GARCH-X
model, outperforming all other hedging strategies for weekly data. For daily data, the conventional
(OLS) model produces the highest VR. Not surprisingly, as can be observed in the table, staying
unhedged is the worst option in both markets. Finally, the best hedging strategy out of all constant
hedge ratio models (naïve, OLS, VECM) for the FTSE/ATHEX-20 market seems to be emanating
from the VECM model, whereas for the FTSE/ATHEX Mid-40 market the conventional (OLS)
model seems to be more appropriate.
The above results are in line with those of Floros and Vougas (2004) for the FTSE/ATHEX-
20 and FTSE/ATHEX Mid-40 markets. However, their analysis is constrained in an in-sample
framework with daily data, and also assume, rather than test, that the MVHR is equal to the
UMHR. This paper uses both daily and weekly data in-sample and out-of-sample frameworks
and examines empirically whether the speculative components of hedges are indeed zero; that is,
whether the MVHRs equals the UMHRs.
The mean value of the bias (Et (Ft+1 ) − Ft ) for the FTSE/ATHEX-20 market is −0.00324
for weekly data and −0.00069 for daily data, with corresponding t-statistics −1.27 and −1.34,
256
M.G. Kavussanos and I.D. Visvikis
Table 3. Portfolio risk-return and hedge ratios.
FTSE/ATHEX-20 FTSE/ATHEX Mid-40 FTSE/ATHEX Mid-40
MVHR Return Variance Expected Variance Utility MVHR Return Variance Variance UMHR Return Variance Expected Utility
(γ ∗ ) (RH,t ) 2
(σH,t ) utility reduction increase (γ ∗ ) (RH,t ) 2
(σH,t ) reduction (γ ∗∗ ) (RH,t ) 2
(σH,t ) utility increase
Panel A: Daily In-Sample

Unhedged 0 −0.000724 0.002761 −0.009007 − − − −0.001345 0.000348 − − −0.001345 0.000348 −0.002388 −
Naïve, γ ∗ = 1 1 −0.000012 0.000440 −0.001332 84.06 0.00767 1 0.000012 0.000088 74.79 1.462 0.000639 0.000298 −0.000255 0.00213
OLS 0.868 −0.000107 0.000383 −0.001256 86.13 0.00775 0.766 −0.000306 0.000061 82.50∗ 1.228 0.000321 0.000165 −0.000175 0.00221
VECM 0.871 −0.000104 0.000382 −0.001250 86.16 0.00776 0.774 −0.000294 0.000061 82.49 1.237 0.000333 0.000169 −0.000175 0.00221
VECM-GARCH 0.876 −0.000057 0.000366 −0.001155 86.74∗ 0.00785∗ 0.789 −0.000306 0.000062 82.14 1.252 0.000735 0.000226 0.000057 0.00245∗
Panel B: Weekly In-Sample
Unhedged 0 −0.003502 0.001519 −0.008059 − − − −0.005162 0.001933 − − −0.005162 0.001933 −0.010962 −
Naïve, γ ∗ = 1 1 0.000018 0.000106 −0.000300 93.02 0.00776 1 −0.000083 0.000126 93.46 1.378 0.001835 0.000610 0.000004 0.01097
OLS 0.953 −0.000148 0.000102 −0.000454 93.29 0.00760 0.897 −0.000608 0.000105 94.55 1.274 0.001310 0.000414 0.000067 0.01103
VECM 0.959 −0.000126 0.000102 −0.000432 93.29 0.00763 0.927 −0.000455 0.000107 94.49 1.304 0.001462 0.000466 0.000063 0.01103
VECM-GARCH 0.962 0.000058 0.000099 −0.000239 93.48∗ 0.00782∗ 0.921 −0.000332 0.000102 94.75∗ 1.299 0.002608 0.000744 0.000375 0.01134∗
Panel C: Daily Out-of-Sample
Unhedged 0 0.001373 0.001355 −0.002692 − − − −0.000457 0.000143 − − −0.000457 0.000143 −0.000886 −
Naïve, γ ∗ = 1 1 0.000039 0.000169 −0.000468 87.53 0.00222 1 0.000037 0.000018 87.16 1.425 0.000247 0.000083 −0.000001 0.00089
OLS 0.868 0.000216 0.000143 −0.000213 89.45∗ 0.00248∗ 0.763 −0.000080 0.000013 90.90 1.188 0.000130 0.000038 0.000015 0.00090
VECM 0.870 0.000213 0.000144 −0.000219 89.37 0.00247 0.772 −0.000075 0.000013 91.04∗ 1.198 0.000135 0.000039 0.000016 0.00090∗
VECM-GARCH 0.878 0.000247 0.000369 −0.000860 72.77 0.00183 0.312 −0.000331 0.000063 55.97 0.738 −0.000242 0.000034 −0.000343 0.00054
Panel D: Weekly Out-of-Sample
Unhedged 0 0.005781 0.000664 0.003789 − − − −0.002785 0.000858 − − −0.002785 0.000858 −0.005919 −
Naïve, γ ∗ = 1 1 0.000222 0.000039 0.000105 94.13 −0.00368 1 0.000121 0.000041 95.19 1.482 0.001523 0.000365 0.000426 0.00635
OLS 0.954 0.000478 0.000035 0.000373 94.73∗ −0.00342∗ 0.896 −0.000181 0.000033 96.20∗ 1.378 0.001220 0.000256 0.000452 0.00637∗
VECM 0.959 0.000451 0.000037 0.000340 94.43 −0.00345 0.926 −0.000094 0.000033 96.16 1.408 0.001308 0.000285 0.000452 0.00637
VECM-GARCH 0.965 −0.002975 0.000125 −0.003350 81.17 −0.00714 0.936 −0.000019 0.000033 96.15 1.418 0.000780 0.000116 0.000432 0.00635
The hedged and (unhedged) portfolio variances and returns are estimated, along with the respective hedge ratios for five different hedge ratio models: They are VECM-GARCH-X, VECM-GARCH, VECM, OLS, naïve strategy by taking
a futures position, which is the same size as the cash position (γ ∗ = 1). In the FTSE/ATHEX-20 market the Biast+1 = 0 in the corresponding futures market, hence the MVHR is appropriate; in the FTSE/ATHEX Mid-40 market the
UMHR is appropriate. However, MVHRs are also presented. Expected utilities (Equation (3)) for k = 3, VRs (Equation (10)) and UIs (Equation (11)) are also shown in the table. ∗ Denotes the model with the greatest variance reduction
(utility increase).
Hedged portfolio return
RH,t = St − γt Ft (1)
Hedged portfolio variance
2 = Var (S − γ F ) = Var (S ) + γ 2 Var (F ) − 2γ Cov (S , F )

σH,t (2)
t t t t t t t t t t t t t
The European Journal of Finance

Expected utility
Et U (RH,t+1 ) = Et (RH,t+1 ) − kVar t (RH,t+1 ); k=3 (3)
Variance reduction (%) of the unhedged position
Var(St ) − Var(RH,t )
VR = × 100 (10)
Var(St )
Utility increase (%) of the unhedged position
UI = Et U (RH,t ) − Et U (St ) (11)
257
respectively; that is, the bias is statistically zero, and thus, in the FTSE/ATHEX-20 market, the
MVHR equals the UMHR, that is, investors use futures for hedging purposes and cannot benefit
for speculative/investment reasons. Thus, the MVHRs produced by the different models (i.e. the
VECM-GARCH, VECM, OLS, etc.) are used in Equation (3), with k = 3, to estimate the expected
utility from the hedges, in the fifth and fifteenth columns of the table.
In the FTSE/ATHEX Mid-40 market, however, the results indicate the existence of a bias
in futures prices, with mean values (t-statistics) of −0.00661 (−2.04) for weekly data and
−0.00137 (−2.03) for daily data. Therefore, for the FTSE/ATHEX Mid-40 market, assuming
that investor’s expectations are formed rationally, the non-zero return of the hedged portfolio
(RH,t ) of Equation (1) and the expected utility function of Equation (3) is derived for each of the
alternative hedging models, by utilising the estimated UMHR of Equation (4) and assuming k =
3. The latter is the MVHR of Equation (5) plus a speculative demand component. The estimated
expected utilities from each of these models are also shown in Table 3.
In the same table, the utility increase with respect to the unhedged position, achieved by each
model, is estimated in each market for both daily and weekly data. As can be observed, the UI
statistic selects the time-varying VECM-GARCH and VECM-GARCH-X models for both daily
and weekly data in the in-sample exercise. The models selected are the same when the MVHR
is used as the model selection criterion. The only exception is for the in-sample daily data, for
which the OLS constant MVHR produces the best results.
However, in the choice between constant and time-varying hedge ratios, an impor-
tant element is the extra transaction costs incurred during the portfolio-rebalancing pro-
cess, in comparison to the constant ratio situation. Consider, for instance, the in-sample
average expected weekly portfolio variances of returns from the hedged positions in the
FTSE/ATHEX-20 market from the OLS and the VECM-GARCH hedge ratios, reported in
Panel B (fourth column) of Table 3; they are 0.000102 and 0.000099, respectively. Then,
on average, the investor obtains a weekly expected utility of Et U (RH,t+1 ) = Et (RH,t+1 ) − k
Vart (RH,t+1 ) = −0.000148 − 3 × (0.000102) = −0.000454 and Et U (RH,t+1 ) = −0.000058 −
3 × (0.000099) − φ = −0.000239 − φ, when the OLS and the VECM-GARCH hedge ratios are
used, respectively; where φ represents the reduced returns caused by the transaction costs (as a
rate of return) incurred due to portfolio rebalancing. Thus, by using the VECM-GARCH model,
over the OLS model, hedgers in the market can benefit from an increase in their average weekly
expected utility of (0.000215 − φ). The VECM-GARCH hedge strategy will be preferred over
the OLS strategy as long as φ < 0.000215; otherwise due to excessive costs it would not be
economically wise to employ the VECM-GARCH hedging strategy. One round trip (one buy and
one sell) for established investors in the FTSE/ATHEX-20 market costs on average ¤16 (= ¤8
buy + ¤8 sell) and in the FTSE/ATHEX Mid-40 market it costs approximately ¤20 (= ¤10 buy
+ ¤10 sell).9 Assuming a margined contract size of ¤1144 (= 2288 index value × 5 multiplier ×
10% margin) for the FTSE/ATHEX-20 and ¤2435.5 (= 4871 index value × 5 multiplier × 10%
margin) for the FTSE/ATHEX Mid-40, transaction costs in percentage terms amount to around
0.01399% (= 16/1144) for the FTSE/ATHEX-20 market and 0.00821% (= 20/2435.5) for the
FTSE/ATHEX Mid-40 market. Therefore, an investor with a mean–variance utility function would
prefer the VECM-GARCH hedging strategy to the OLS strategy, as φ = 0.0001399 < 0.000215
in the FTSE/ASE-20 market and φ = 0.0000821 < 0.000308 in the FTSE/ASE Mid-40 market.
4.2.2 Out-of-Sample hedge ratios

Although the in-sample performance of the alternative hedging strategies provides an indication
of their historical performance, investors are more concerned about how well they can do in the
future. In order to investigate that, we use an initial portion of the sample for estimation and
reserve the remaining sample for out-of-sample forecasting. Following Tashman (2000), non-
overlapping independent out-of-sample N-period ahead forecasts are generated over the forecast
period. In order to avoid the bias induced by serially correlated overlapping forecast errors, the
estimation period is augmented recursively by N -periods ahead every time (where N corresponds
to the number of steps ahead). In the case of non-independent forecasts, a shock in a specific
forecast horizon may affect all other forecasting horizons. Thus, non-overlapping independent
observations desensitise forecast error measures to special events and specific phases of business
(Geppert 1995).
Thus, for the weekly data, we withhold 30 weekly observations at the end of the sample (i.e. 19
November 2003 to 7 June 2004, representing a period of 7 months) and estimate the conditional
models using only the data up to 12 November 2003. Then, we perform one-step (one-week)-
ahead forecasts of the covariance and the variance for 19 November 2003. These are then used to
estimate the one-step-ahead forecast of the hedge ratio for that week. Then, the following week,
the observation of 19 November 2003 is added to the sample and the exercise is repeated, again
forecasting the hedge ratio of the following week. We continue updating the models by adding
one weekly observation at a time to the estimated model and forecasting the hedge ratios until
the end of our data set. The results for the out-of-sample hedging effectiveness are presented in
Panels C and D of Table 3. The same table reports the results of the corresponding exercise using
daily data. For that, in both markets, we withhold 135 daily observations at the end of the sample;
that is, 19 November 2003 to 7 June 2004, representing again a period of 7 months and estimate
the conditional models using only the data up to 19 November 2003. We then follow the same
procedure as described above for the weekly data, but this time by adding one daily observation
at a time.
In contrast to the in-sample results, in the FTSE/ATHEX-20 market the VECM-GARCH model
seems to perform the worst (81.17% and 72.77% variance reductions and −0.00714 and 0.00183
utility increases, for weekly and daily data, respectively), compared with the alternative constant
hedging strategies. The highest VR/utility increase is achieved by the conventional (OLS) model
(VR 94.73% and 89.45% and UI −0.00342 and 0.00248 for weekly and daily data, respectively),
followed at lower values by the VECM, the naïve model and the VECM-GARCH.
In the FTSE/ATHEX Mid-40 market also the VECM-GARCH-X model has the worst per-
formance (VR 96.15% and 55.97% and UI 0.00635 and 0.00054, for weekly and daily data,
respectively), compared with the alternative constant conventional (OLS) and VECM hedging
strategies. The highest VR and utility increase is achieved by the OLS model for weekly data (VR
96.20% and UI 0.00637) and by the VECM model for daily data (VR 91.04% and UI 0.0007).10
It can be argued that when the speculative components are taken into account in the optimal hedge
ratio calculations (like in the case of the FTSE/ATHEX Mid-40 market), investors can increase
the utility they derive from their hedges beyond the level obtained through risk-minimisation
strategies. This is because the increased benefits from speculation outweigh the costs, for the
particular level of risk aversion of the assumed investor (k = 3).
These results seem to be in accordance with the literature: Lence (1995) argues that the benefits
of sophisticated estimation techniques of the hedge ratio are small and that hedgers may do
better by focusing on simpler and more intuitive hedge models. Lien, Tse, and Tsui (2002) by
examining 10 cash and futures markets, covering currency futures, commodity futures and stock
index futures in the NYSE and S&P500 markets, report that OLS hedge ratios perform better
than the vector GARCH hedge ratios. However, there seems to be a conflict in the literature about
GARCH hedge ratios, as some studies report that they outperform, in terms of risk reduction, the
constant hedge ratios (Gagnon and Lypny 1997). But these gains are market-specific and vary
across different contracts, whereas, occasionally, the benefits in terms of risk reduction seem to be
minimal (Lien and Tse 2002). Therefore, the differences in the performance of GARCH models
in hedge ratio estimation appear to be a consequence of different hedging horizons, different
market conditions, different futures contract specifications, different levels of trading and other
market-specific and/or contract-specific economic differences. At the end, whether constant or
time-varying hedge ratios are more appropriate is a matter of empirical evidence, and this paper
contributes to answering this empirical question, from the Greek markets’ point of view.
It may be argued that time-varying VECM-GARCH hedge ratios need to be updated and
rebalanced as new information, regarding cash and futures prices, appears in the market. However,
in a thin trading futures market, such as the ATHEX market, information arrival and assimilation
is not as fast as in other well-developed and liquid derivatives markets, which would justify the
use of time-varying hedge ratio models in the latter markets. Overall, the results, from both daily
and weekly data, reveal that in the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 markets, the
relationship between cash and futures prices is quite stable and market agents can use simple
constant hedge models in order to obtain out-of-sample optimum hedge ratios.
Furthermore, the results reveal that futures contracts serve their risk management function
through hedging, as they provide considerable VRs in comparison to staying unhedged. In the
FTSE/ATHEX-20 market the greatest VR is 94.73% when using weekly data, whereas in the
FTSE/ATHEX Mid-40 market this figure is 96.20%. These figures are approximately 5% and 3%
lower when using daily data. Coupling of these lower hedging effectiveness figures, when using
daily data with the higher transactions costs points to using weekly rather than daily rebalancing
of portfolios by market practitioners.
The magnitude of the hedging effectiveness measures is more or less comparable with other
studies in the literature (most of which use weekly data) on stock index futures contracts, which
show VRs of: 90% for the Swiss Market Index futures (Stulz, Wasserfallen, and stucki 1990),
87% for the Hang Seng futures (Yau 1993), 94% for the FTSE-100 futures (Lee 1994), 97.91%
and 77.47%, respectively, for the S&P500 and the Canadian stock index futures contracts (Park
and Switzer 1995), 88% for the Spanish Ibex 35 futures (Lafuente and Novales 2003), 96.41% and
96.70% for the S&P500 and NASDAQ-100 stock index futures, respectively (Chiu et al. 2005),
96.82% for the Nikkei 225 futures (Lee 2006), 97% for the Swedish OMX-index futures (Norden
2006) and 95.28% for the Nikkei 225 and 95.61% the Hang Seng index futures (Lee and Yoder
2007). It can be noticed that hedging effectiveness seems to be slightly higher in more recent
studies.
4.2.3 Risk-aversion effects, cost of hedging and optimal solutions

To investigate the sensitivity of the utility results to different values of the risk-aversion coefficient
(k), utility comparisons associated with alternative hedge ratios for a range of different risk-
aversion coefficients are made, for daily and weekly frequencies, both in-sample and out-of-
sample. For a range of values of k (0.1, 0.5, 1, 1.5, 2, 3 and 4) the utility levels for unhedged
and hedged portfolios are estimated using the portfolio’s mean and variance of returns following
estimation of UMHRs.
For instance, Panel A of Table 4 presents the weekly and daily in-sample utilities for the
FTSE/ATHEX-20 market. With the exception of daily data for risk-aversion levels at the low
range 0.1–0.5, where the naïve hedge ratio is preferred, the results, for both weekly and daily data,
indicate that the VECM-GARCH model is the most preferred across all levels of risk aversion,
as it provides the greatest level of utility. Out-of-sample, for weekly data, the VECM-GARCH
Table 4. Utility maximisation hedging effectiveness comparison.
Panel A: FTSE/ATHEX-20 In-sample expected utilities

Weekly k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗ = 0 −0.003403 −0.004010 −0.004770 −0.005529 −0.006289 −0.008059 −0.009327
Naïve, γ ∗ = 1 −0.000521 −0.000563 −0.000616 −0.000669 −0.000722 −0.000300 −0.000934
OLS −0.000286 −0.000327 −0.000378 −0.000429 −0.000480 −0.000454 −0.000684
VECM −0.000263 −0.000304 −0.000355 −0.000406 −0.000457 −0.000432 −0.000661
VECM-GARCH −0.000150 −0.000189 −0.000239 0.000288 −0.000338 −0.000239 −0.000536
Daily k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗ = 0 −0.000959 −0.002064 −0.003444 −0.004825 −0.006205 −0.009007 −0.011727
Naïve, γ ∗ = 1 −0.000061 −0.000237 −0.000457 −0.000677 −0.000897 −0.001332 −0.001777
OLS −0.000150 −0.000303 −0.000494 −0.000686 −0.000877 −0.001256 −0.001643
VECM −0.000147 −0.000300 −0.000491 −0.000682 −0.000873 −0.001250 −0.001637
VECM-GARCH −0.000093 −0.000239 −0.000422 −0.000605 −0.000788 −0.001155 −0.001520
Panel B: FTSE/ATHEX-20 out-of-sample expected utilities
Weekly k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗ = 0 −0.003317 −0.003583 −0.003915 −0.004247 −0.004579 0.003789 −0.005907
Naïve, γ ∗ = 1 −0.000624 −0.000639 −0.000659 −0.000678 −0.000698 0.000105 −0.000776
OLS −0.000547 −0.000561 −0.000578 −0.000596 −0.000613 0.000373 −0.000683
VECM −0.000566 −0.000580 −0.000599 −0.000617 −0.000636 0.000340 −0.000710
VECM-GARCH −0.000262 −0.000312 −0.000374 −0.000437 −0.000499 −0.003350 −0.000749
Daily k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗ = 0 −0.000819 −0.001361 −0.002038 −0.002716 −0.003393 −0.002692 −0.006103
Naïve, γ ∗ = 1 −0.000035 −0.000102 −0.000187 −0.000271 −0.000356 −0.000468 −0.000694
OLS −0.000077 −0.000134 −0.000205 −0.000277 −0.000348 −0.000213 −0.000634
VECM −0.000076 −0.000134 −0.000206 −0.000278 −0.000350 −0.000219 −0.000638
VECM-GARCH −0.000154 −0.000301 −0.000486 −0.000670 −0.000855 −0.000860 −0.001593
Panel C: FTSE/ATHEX Mid-40 In-sample expected utilities
Weekly k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗∗ = 0 −0.005355 −0.006128 −0.007095 −0.008062 −0.009028 −0.010962 −0.012895
Naïve, γ ∗∗ = 1 0.001774 0.001529 0.001224 0.000919 0.000614 0.000004 −0.000607
OLS 0.001268 0.001103 0.000895 0.000688 0.000481 0.000067 −0.000348
VECM 0.001415 0.001229 0.000996 0.000763 0.000529 0.000063 −0.000403
VECM-GARCH-X 0.002534 0.002236 0.001864 0.001492 0.001119 0.000375 −0.000370
Daily k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗∗ = 0 −0.001372 −0.001511 −0.001684 −0.001858 −0.002031 −0.002377 −0.002724
Naïve, γ ∗∗ = 1 0.000609 0.000490 0.000341 0.000192 0.000043 −0.000255 −0.000553
OLS 0.000305 0.000239 0.000156 0.000073 −0.000009 −0.000175 −0.000340
VECM 0.000316 0.000248 0.000164 0.000079 −0.000006 −0.000175 −0.000344
VECM-GARCH-X 0.000713 0.000622 0.000509 0.000396 0.000283 0.000057 −0.000170
Panel D: FTSE/ATHEX Mid-40 out-of-sample expected utilities
Weekly k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗∗ = 0 −0.002871 −0.003214 −0.003643 −0.004072 −0.004501 −0.005359 −0.006217
Naïve, γ ∗∗ = 1 0.001486 0.001340 0.001157 0.000975 0.000792 0.000426 0.000061
OLS 0.001195 0.001092 0.000964 0.000836 0.000708 0.000452 0.000197
VECM 0.001279 0.001165 0.001022 0.000880 0.000737 0.000452 0.000166
(Continued)
Table 4. Continued.
VECM-GARCH-X 0.000768 0.000722 0.000664 0.000606 0.000548 0.000432 0.000316

Daily k = 0.1 k = 0.5 k=1 k = 1.5 k=2 k=3 k=4
Unhedged, γ ∗∗ = 0 −0.000471 −0.000528 −0.000600 −0.000672 −0.000743 −0.000886 −0.001030
Naïve, γ ∗∗ = 1 0.000239 0.000206 0.000164 0.000123 0.000082 −0.000001 −0.000083
OLS 0.000126 0.000111 0.000092 0.000073 0.000054 0.000015 −0.000023
VECM 0.000131 0.000115 0.000095 0.000075 0.000056 0.000016 −0.000023
VECM-GARCH−X −0.000245 −0.000259 −0.000276 −0.000293 −0.000309 −0.000343 −0.000377
This table presents the hedging effectiveness comparison from the expected utility maximization Equation (3) for a range
of values of the risk aversion coefficient (k = 0.1, 0.5, 1.0, 1.5, 2.0, 3.0, and 4.0), using both daily and weekly data, over
both in-sample and out-of-sample periods. The utility levels for unhedged and hedged portfolios are estimated using the
portfolio’s mean and variance of return.
model is still the most preferred one, but when daily data are used the naïve (for levels of risk
aversion 0.1, 0.5, 1.0 and 1.5) and the conventional (OLS) models (for levels of risk aversion 2.0,
3.0 and 4.0) are the most preferred. For the FTSE/ATHEX Mid-40 market, presented in Panels
C and D of Table 4, in-sample the VECM-GARCH-X model is the most preferred, irrespective
of the risk-aversion level. Out-of-sample, for values of the risk-aversion coefficient from 0.1 to
2, the naïve model is the most preferred, however, for higher risk-aversion levels, the OLS and
the VECM models are preferred for weekly and daily data, respectively. Overall, it seems that
the risk-aversion coefficient influences the selection of the ‘best’ hedge ratio model, which is also
influenced by the data frequency, the hedging forecast horizon (in-sample vs. out-of-sample) and
the futures contract investigated (FTSE/ATHEX-20 or FTSE/ATHEX Mid-40).
In the same table, comparison of the estimated maximised expected utility levels from the ‘best’
model (giving maximum utility) for each market (e.g. FTSE/ATHEX-20), frequency (e.g. weekly
data) and decision horizon (e.g. in-sample) reveals an inverse relationship between expected utility
and the magnitude of the risk-aversion coefficient. For instance, in the FTSE/ATHEX-20 market,
in-sample and for weekly data, the higher the risk-aversion coefficient, the lower is the expected
utility from the hedging decision process.
The previous exercise, in estimating ex-post optimal hedge ratios, is repeated utilising this
time a much wider range of levels of risk-aversion coefficients (10,000, 1000, 900, 800, 700,
600, 500, 400, 300, 200, 100, 10, 1, 0.1, 0.01, 0.001), using the weekly in-sample FTSE/ATHEX
Mid-40 futures as an example. Table 5 reports optimal UMHRs at different levels of risk-aversion
coefficients, as well as associated portfolio returns, standard deviations and expected utility levels.
For small values of k (i.e. 0.0001 to 10), the optimal UMHRs (γ ∗∗ ) vary greatly, as well as the
corresponding portfolio returns and standard deviations. However, for values of k above 200, the
optimal hedge ratio is almost constant, implying that the speculative component does not play a
role in optimisation solutions of such risk-averse investors.
Next, we create a mean–standard deviation portfolio opportunity frontier, which describes the
return and risk trade-offs from hedging. The FTSE/ATHEX Mid-40 futures contract is investigated
as an example (the corresponding figures for the FTSE/ATHEX-20 market are qualitatively the
same). Table 6 reports the daily out-of-sample results for the portfolio returns (Equation (1)) and
standard deviations (Equation (2)) for values of the UMHRs (γ ∗∗ ) between 0 and 1.6. This return–
risk trade-off for different values of γ ∗∗ is also shown in Figure 1. The highest risk is related with
the unhedged portfolio (γ ∗∗ = 0), whereas the minimum risk portfolio corresponds to a hedge
ratio of approximately 0.8, with an associated return of −0.000062 and a standard deviation
of 0.003527. In fact, as γ ∗∗ increases from 0 to 0.8, portfolio risk falls and return increases.
Table 5. Optimal hedge ratios at different levels of risk aversion of

FTSE/ATHEX Mid-40 futures.
Risk Optimal Portfolio Portfolio St. Expected

aversion, k UMHR, γ ** return deviation utility
10,000 0.922 −0.00033 0.000102 −1.0160

1000 0.922 −0.00032 0.000102 −0.1021
900 0.922 −0.00032 0.00010 −0.0920
800 0.923 −0.00032 0.00010 −0.0818
700 0.923 −0.00032 0.00010 −0.0716
600 0.923 −0.00032 0.00010 −0.0615
500 0.924 −0.00031 0.00010 −0.0513
400 0.925 −0.00031 0.00010 −0.0412
300 0.926 −0.00030 0.00010 −0.0310
200 0.928 −0.00029 0.00010 −0.0209
100 0.936 −0.00024 0.000104 −0.0107
10 1.076 0.00055 0.000176 −0.0012
1 2.467 0.00849 0.005410 0.0031
0.1 16.383 0.08786 0.50947 0.0369
0.01 155.54 0.88168 50.7229 0.3744
0.001 1547.1 8.81970 5,070.1 3.7496
0.0001 15,462.6 88.2009 506,992.5 37.501
Weekly in-sample portfolio return, risk, expected utility and UMHR estimates are
calculated using Equations (1), (2), (3) and (4), respectively, for different levels of the
risk aversion coefficient (k).
For values of γ ∗∗ above 0.8 portfolio return increases further, but risk is also increasing now.
This figure describes the risk–return trade-off for the portfolio (of cash and futures contracts)
holder in the FTSE/ATHEX Mid-40 market. Withholding no derivatives in his portfolio will
provide 0.011970 risk and a negative return of −0.000457. When futures contracts are combined
with the cash position portfolio return increases and risk falls up to a maximum fall of 0.003527.
Therefore, when more futures contracts are included in the portfolio; that is, as γ ∗∗ keeps increasing
– essentially exploiting the opportunity offered by the biased futures FTSE/ATHEX Mid-40
market (shown earlier in the paper) – there are opportunities for greater returns to be made in this
cash–futures portfolio. Thus, the dilemma for the portfolio holder amounts to selecting a point on
this efficient frontier that would maximise the expected utility from the combined cash-derivatives
position. The more risk averse the portfolio holder (see also implied k in the second column of
Table 6), the closer the γ ∗∗ should be to 0.8. Of course, the upper part of the efficient frontier
curve dominates the bottom part, as it would offer higher returns for each level of risk.
The above decisions are influenced not only by the level of risk aversion, but also from costs.
Thus, the hedger should be rewarded for the decrease in return by an adequate decrease in risk. To
this effect, the returns and the variances of the unhedged and hedged positions can be compared
for various values of γ ∗∗ through the following cost of hedging measure:
% reduction in return
Cost of hedging = (12)
% reduction in variance
where % Reduction in return = 1 – [(hedged return)/(unhedged return)] and % Reduction in

variance = 1 – [(hedged variance)/(unhedged variance)].
Table 6. Portfolio risk-return trade-offs of FTSE/ATHEX Mid-40 futures.
Optimal Portfolio Portfolio St. Portfolio % Reduction % Reduction Cost of

UMHR, γ ** Implied k return deviation variance in return in variance hedging
0 −0.00000025 −0.000457 0.011970 0.000143

0.1 −0.00000028 −0.000407 0.010649 0.000113 10.8 20.9 0.52
0.2 −0.00000033 −0.000358 0.009347 0.000087 21.6 39.0 0.55
0.3 −0.00000040 −0.000309 0.008075 0.000065 32.4 54.5 0.60
0.4 −0.00000051 −0.000259 0.006850 0.000047 43.2 67.3 0.64
0.5 −0.00000070 −0.000210 0.005700 0.000032 54.1 77.3 0.70
0.6 −0.00000111 −0.000160 0.004684 0.000022 64.9 84.7 0.77
0.7 −0.00000264 −0.000111 0.003906 0.000015 75.7 89.4 0.85
0.8 0.00000687 −0.000062 0.003527 0.000012 86.5 91.3 0.95
0.9 0.00000149 −0.000012 0.003672 0.000013 97.3 90.6 1.07
1 0.00000084 0.000037 0.004290 0.000018 108.1 87.2 1.24
1.1 0.00000058 0.000086 0.005215 0.000027 118.9 81.0 1.47
1.2 0.00000045 0.000136 0.006312 0.000040 129.7 72.2 1.80
1.3 0.00000036 0.000185 0.007508 0.000056 140.5 60.7 2.32
1.4 0.00000030 0.000234 0.008761 0.000077 151.4 46.4 3.26
1.5 0.00000026 0.000284 0.010051 0.000101 162.2 29.5 5.50
1.6 0.00000023 0.000333 0.011364 0.000129 173.0 9.9 17.53
Daily out-of-sample portfolio return and risk estimates are calculated using Equations (1) and (2), respectively, for
different levels of the UMHR (γ ∗∗ = 0, …, 1.6). The implied risk aversion parameter is estimated in every case
using k = −(Biast+1 )/[2(γ ∗∗ − γ ∗ ) Var(Ft+1 )]. The % Reduction in Return = 1 – [(Hedged Return)/(Unhedged
Return)] and the % Reduction in Variance = 1 – [(Hedged Variance)/(Unhedged Variance)]. The Cost of Hedging =
(% Reduction in Return) / (% Reduction in Variance). Bold indicates the minimum-standard deviation portfolio.
Figure 1. Return-risk trade-offs from hedging with FTSE/ATHEX Mid-40 futures. The numbers on the
portfolio opportunity frontier refer to UMHR (γ ∗∗ ). The estimate 0.8 corresponds to the minimum-standard
deviation portfolio.
The above cost of hedging estimates for the specific period under evaluation are shown in
the last column of Table 6, with larger estimates implying higher costs of risk reduction. The
minimum standard deviation portfolio corresponds to a cost of 0.95, which implies that a 1%
reduction in risk will result in a 0.95% reduction in return. A hedger then has to decide whether
this risk reduction cost is reasonable enough for his risk aversion level. Of course, the risk–return
trade-offs shown here may be different for a different period.
4.2.4 Optimal rebalancing frequency

An investor’s anticipated trading frequency or investment horizon is seen as one of the most
important factors affecting the asset allocation and investment decisions for financial asset holding
(Douglas Van Eaton and Conover 2002). In the case of active asset management, the optimal
holding horizon, which determines a specific trading strategy, represents how actively (frequently)
investors should trade to maximise post-transaction cost profits. However, so far there is only a
few papers attempting to find the optimal trading frequency for a financial asset or a portfolio
and there is no consensus on the selection of the data frequency relative to the expected holding
horizon (Dunis and Miao 2004). Mian and Adam (2001), among others, argue that the appropriate
sampling frequency depends on the particular context. For example, if long-term forecasts are
needed, a low-frequency data estimated model would be the appropriate one.
There are two different categories of techniques used to find the optimal trading frequency. First,
fundamental analysis is used, despite the fact that the process of finding the right parameters for
fundamental models could be time-consuming and indecisive. Second, technical rules, such as
volatility filters and model switching strategies, are used, but their results are influenced from the
selection of parameters and the addition of certain filters. Thus, results coming from trading rules
are sensitive in terms of the selected data frequencies and thus, different trading frequencies can
be derived.
Dunis and Miao (2004) apply technical trading rules to investigate the optimal trading frequency
question in seven futures contracts, for the period January 1998–March 2004.11 The results indicate
that technical trading rules perform poorly in periods when market volatility is high. The two
volatility filters proposed, namely the no-trade filter, where all market positions are closed in
volatility periods and the reverse filter, where signals from a simple Moving Average Convergence
and Divergence (MACD) system are reversed if the market volatility is higher than a given
threshold, improve the futures performance in most cases when applied not to single assets but
to portfolios of assets. Dunis and Miao (2004) report that the results for the optimal trading
frequencies differ for different assets under review. More specifically, the results for stock index
futures indicate that the optimal trading frequency is around 2–4 trades per year. For aluminium,
copper and brent oil futures the optimal annual number of trades are 12–18, 6–7 and 32–42,
respectively. Finally, for the bond futures the optimal trading frequencies are 5–8 and 11–18
trades per year for the 30-year T-bond and for the 10-year Bund futures, respectively. They
conclude that the differences in the optimal rebalancing frequency among the assets investigated
much depend on the model and strategies employed and on the specific market characteristics of
each asset.
Generally speaking, mean–variance expected utility-maximising investors prefer time-varying
hedge strategies to conventional ones and only rebalance their portfolios when the increased
expected utility from rebalancing is greater than the transactions costs (φ) incurred from updating
the hedge (Kroner and Sultan 1993, among others). Thus, the mean–variance expected utility-
maximising investor will rebalance at time t if and only if

RH,t − φ − k Var(RH,t ) > RH,t − k Var(RH,t ) (13)
where RH,t = (St − γt∗ Ft ) and Var(RH,t ) = [Var(St ) + γt∗2 Var(Ft ) − 2γt∗ Cov(St ,
Ft )] are the expected return and variance of the rebalanced portfolio (estimated with the use of a

time-varyingVECM-GARCH hedge ratio model say), respectively, while RH,t = (St − γt∗ Ft )
∗2 ∗
and Var(RH,t ) = [Var(St ) + γt Var(Ft ) − 2γt Cov(St , Ft )] are the return and variance
of the non-rebalanced portfolio (estimated with the use of a constant OLS hedge ratio model
Table 7. Optimal rebalancing frequency, VECM-GARCH-X vs. OLS.
Panel A: FTSE/ATHEX-20
Weekly frequency
k 0.1 0.5 1 1.5 2 2.5 3 4
In-sample 0 0 162 214 214 214 214 214
Out-of-sample 0 0 0 24 30 30 30 30
Daily frequency
k 0.1 0.5 1 1.5 2 2.5 3 4
In-sample 0 0 239 1149 1151 1151 1151 1151
Out-of-sample 0 0 3 59 130 135 135 135
Panel B: FTSE/ATHEX Mid-40

Weekly frequency
k 0.1 0.5 1 1.5 2 2.5 3 4
In-sample 187 183 165 148 119 93 68 46
Out-of-sample 0 0 0 0 0 0 0 0
Daily frequency
k 0.1 0.5 1 1.5 2 2.5 3 4
In-sample 1069 1012 809 662 530 392 294 187
Out-of-sample 0 0 0 0 0 0 0 0
The number of portfolio rebalances made by the investor are presented, when the potential gains in
utility from the reduced variance offset the transactions costs that are incurred, for different levels
of the risk aversion coefficient (k). Equation (13) is used to estimate the mean-variance portfolios of
the VECM-GARCH-X and OLS models. It is estimated that the transactions costs (φ) are 0.01399%
and 0.00821% in the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 markets, respectively. In the
FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 markets, the γt∗ and the γt∗∗ hedge ratios are used,
respectively. In-sample, in the FTSE/ATHEX-20 market there are 249 hedging weeks and 1185
hedging days in-sample, whereas in the FTSE/ATHEX Mid-40 market there are 226 hedging
weeks and 1081 hedging days. Out-of-sample, in both markets, there are 30 hedging weeks and
135 hedging days.
say).12 That is, both models of the equation are estimated for each period and the hedger will
rebalance if the expected utility from the rebalanced portfolio is greater than the constant one
(where no rebalancing takes place). Equivalently, this would be the case if the number of times
the left-hand side of Equation (13) is greater than the right-hand side of the same equation.
Panel A of Table 7 presents the number of portfolio rebalances made by the investor, under
weekly frequencies, for different levels of the risk-aversion coefficient (k), assuming in-sample
estimates. The results indicate that in the FTSE/ATHEX-20 futures market (using φ = 0.01399%)
the investor will choose to rebalance his portfolio 214 times on average, out of a total of 249
weeks (data sample), in-sample, for the higher levels of the risk-aversion coefficient (1.5–4). This
indicates that on average 214 times the left-hand-side estimate of Equation (13), derived from the
use of time-varying (VECM-GARCH) hedge ratios, was found larger than the right-hand-side
estimate, derived from the use of constant (OLS) hedge ratios. Thus, a time-varying hedge ratio
model, with rebalancing transaction costs, on average, is more preferable than a constant hedge
ratio model with no rebalancing transaction costs. The same investor out-of-sample will choose
to rebalance his portfolio 30 times on average (out of a total of 30 weeks) for higher levels of the
risk-aversion coefficient (2–4), but for levels of the risk-aversion coefficient below 1.5 he chooses
not to rebalance at all, indicating that constant (conventional – OLS) models are more preferable
for low levels of risk aversion. The daily frequency results, presented in the same table, are in line
with the weekly results. That is, the investor, for the higher levels of the risk-aversion coefficient,
will rebalance his portfolio 1151 times, on average, out of a total of 1181 days (data sample),
in-sample, and will rebalance his portfolio 135 times, on average, out of a total of 135 days, out-of-
sample. However, for values of the risk-aversion coefficient below 1, he chooses not to rebalance
at all. Therefore, for the FTSE/ATHEX-20 market, it seems that the sample frequency (daily vs.
weekly) and the forecast period (in-sample vs. out-of-sample) do not constitute important factors
for hedgers that influence their portfolio rebalancing choices. On the other hand, however, the
choice of the level of the risk-aversion coefficient seems to be an important factor that affects
portfolio-rebalancing choices.13
In the FTSE/ATHEX Mid-40 futures market (using φ = 0.00821%), the in-sample results in
Panel B of the same table indicate that under weekly frequencies the investor rebalances his
portfolio 187 times for k = 0.1 down to 46 times for k = 4, out of a total of 226 weeks. Under
daily frequencies, the investor rebalances his portfolio 1069 times for k = 0.1 down to 187 times
for k = 4, out of a total of 1081 days. From the out-of-sample results it is apparent that the
constant (OLS) models are preferable for all levels of the risk-aversion coefficient (k), as the
right-hand-side estimate of Equation (13) is found to be larger than the left-hand-side estimate
and consequently, the investor chooses not to rebalance at all. The results for the FTSE/ATHEX
Mid-40 market are in line with the previous results of Table 3, where in-sample the time-varying
VECM-GARCH-X models are found to be the most preferable, but out-of-sample simple constant
regression models are sufficient.12 In contrast with the above findings for the FTSE/ATHEX-20
market, in the FTSE/ATHEX Mid-40 market it seems that the forecast period (in-sample vs. out-
of-sample) constitute an important factor for portfolio-rebalancing choices, irrespective of the
level of the risk-aversion coefficient. The discrepancy in the results between the FTSE/ATHEX-
20 and the FTSE/ATHEX Mid-40 markets may be due to the different liquidity trading levels of
the two futures contracts and the different composition of the underlying cash indices.
5. Conclusion
This paper examined the hedging effectiveness in terms of both VR and expected utility increase, of
investors taking hedges in the FTSE/ATHEX-20 and FTSE/ATHEX Mid-40 stock index futures
contracts in Greece. In both markets, cash and futures prices are cointegrated, thus standing in
a long-run relationship between them. Using weekly and daily data, both in-sample and out-of-
sample hedging performances are examined in these markets, considering alternative models that
allow for the estimation of both constant and time-varying optimal hedge ratios. Results from
in-sample tests indicate that time-varying hedge ratios outperform alternative specifications in
reducing market risk in some cases, whereas those from out-of-sample tests indicate that constant
hedge ratios, coming from simpler models, provide maximum VRs and utility increases. Utility
and variance comparisons between weekly and daily data point to weekly rebalancing choices,
providing better results for the hedger, compared to daily ones.
Overall, the results reveal that the two-stock index futures contracts on ADEX serve their risk
management function through hedging, as they provide considerable VRs/utility increases in
comparison to unhedged positions. Investors who are interested in the Greek stock index market
can benefit from these results by developing appropriate hedge ratios in each market, in order to
reduce their price risk more efficiently. This paper has contributed in making this issue clear for
the Greek stock market.
Acknowledgements
The authors thank Dr. Nikos Porfiris from the Athens Derivatives Exchange for providing the data. Thanks are also
due for their comments to the editor and two anonymous referees, as well as participants of the following seminars
and conferences, where earlier versions of this study were presented: International Conference on Advances in Applied
Financial Economics (AFE), Samos, Greece, May 2004; 8th Annual European Conference of the Financial Management
Association International (FMA), Zurich, Switzerland, June 2004 and University of Piraeus, May 2006.
Notes
1. Detailed contract specifications of the two futures contracts can be found on the ADEX website (www.adex.ase.gr),
while the names of the companies, comprising each of the underlying indices, the ATHEX-20 and the ATHEX Mid-40
may be found on the ATHEX website (www.ase.gr).
2. Return-variance maximisation is equivalent to variance minimisation, provided expected returns are zero.
3. Several other specifications are also used, such as a bivariate VECM-EGARGH (Nelson 1991) and a VECM-GJR-
GARCH (Glosten Jagannathan and Runkle 1993), but yield inferior results judged by the evaluation of the log-
likelihood values and from diagnostic tests on standardised residuals. These are available from the authors on request.
4. The use of the lagged squared ECT specification, instead of the lagged level or the lagged absolute value specifications
is justified in the empirical work as most of the times it provides uniformly superior results (Lee 1994). It should be
noted that the lagged squared ECT specification is used, instead of the lagged squared basis, as the restrictions placed
on the cointegrating vector to represent the exact lagged basis are rejected in both markets (not shown).
5. Cointegration test results are available from the authors on request.
6. Results from daily data are qualitatively the same as those with weekly data. They are not presented here for economy
of space, but can be obtained from the authors on request.
7. Results from daily data are qualitatively the same as those with weekly data and can be obtained from the authors on
request.
8. Kroner and Sultan (1993) report this parameter to be 4; Chou (1988) reports it to be 4.5 and Poterba and Summers
(1986) report it to be 3.5. For more details regarding the empirical estimation of the parameter k see Poterba and
Summers (1986).
9. The brokers commission for an order (buy or sell) in the FTSE/ATHEX-20 market ranges from 3¤ (for large investors)
to 20¤ and in the FTSE/ATHEX Mid-40 market it ranges from 3¤ (for large investors) to 25¤.
10. The VECM-GARCH-X model, for the FTSE/ATHEX Mid-40 market is also estimated without the inclusion of a
lagged squared ECT in the variance equation, in order to verify that the results are not affected by this term. The
results are qualitatively the same and are available from the authors upon request.
11. The futures contacts investigated are: the S&P500 futures, trading at the Chicago Mercantile Exchange (CME); the
Euro STOXX50 and the 10-year Bund futures, trading at EUREX; the 30-year T-Bond futures, trading at the Chicago
Board of Trade (CBOT); the Copper and Aluminium futures, trading at the London Mercantile Exchange (LME);
and the Brent Oil futures, trading at Intercontinental Exchange (ICE).
12. For the estimation of Equation (13) it should be noted that γ ∗t is used in the FTSE/ATHEX-20 market, while γ ∗∗ t is
used in the FTSE/ATHEX Mid-40 market.
13. Comparisons are also made between the time-varying VECM-GARCH-X models and the constant VECM models,
yielding qualitatively similar results (not reported).
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The European Journal of Finance,

Vol. 14, No. 3, April 2008, 243–270

Hedging effectiveness of the Athens stock index futures contracts

Manolis G. Kavussanosa∗ and Ilias D. Visvikisb

∗ Corresponding author. Email: mkavus@aueb.gr

2. Optimal hedge ratio models

RH,t = St − γt Ft (1)

Et U (RH,t+1 ) = Et (RH,t+1 ) − kVar t (RH,t+1 ) (3)

2.1 Empirical models for the estimation of optimal hedge ratios

covariances and lagged cross-products of the error terms.4

2.2 Hedge ratios and hedging effectiveness measures

4.1 Estimated models

M.G. Kavussanos and I.D. Visvikis

Table 2. Maximum likelihood estimates of VECM-GARCH-X models. (FTSE/ATHEX-20:

Panel A: Conditional Mean Parameters

Ht = A A + B Ht−1 B + C εt−1 εt−1

selected. In the FTSE/ATHEX Mid-40 market, a VECM-GARCH(1,1)-X model is appropriate,

4.2 Hedging effectiveness results

FTSE/ATHEX-20 FTSE/ATHEX Mid-40 FTSE/ATHEX Mid-40

Panel A: Daily In-Sample

RH,t = St − γt Ft (1)

Hedged portfolio variance

2 = Var (S − γ F ) = Var (S ) + γ 2 Var (F ) − 2γ Cov (S , F )

The European Journal of Finance

Et U (RH,t+1 ) = Et (RH,t+1 ) − kVar t (RH,t+1 ); k=3 (3)

Variance reduction (%) of the unhedged position

Utility increase (%) of the unhedged position

UI = Et U (RH,t ) − Et U (St ) (11)

4.2.2 Out-of-Sample hedge ratios

4.2.3 Risk-aversion effects, cost of hedging and optimal solutions

Table 4. Utility maximisation hedging effectiveness comparison.

Panel A: FTSE/ATHEX-20 In-sample expected utilities

VECM-GARCH-X 0.000768 0.000722 0.000664 0.000606 0.000548 0.000432 0.000316

Table 5. Optimal hedge ratios at different levels of risk aversion of

Risk Optimal Portfolio Portfolio St. Expected

10,000 0.922 −0.00033 0.000102 −1.0160

where % Reduction in return = 1 – [(hedged return)/(unhedged return)] and % Reduction in

Table 6. Portfolio risk-return trade-offs of FTSE/ATHEX Mid-40 futures.

Optimal Portfolio Portfolio St. Portfolio % Reduction % Reduction Cost of

0 −0.00000025 −0.000457 0.011970 0.000143

4.2.4 Optimal rebalancing frequency

Table 7. Optimal rebalancing frequency, VECM-GARCH-X vs. OLS.

Panel B: FTSE/ATHEX Mid-40

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Ht = A A + B Ht−1 B + C εt−1 εt−1