Effectiveness of Hedging & Hedge Ratio Estimation

EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION
RESEARCH PROJECT
On
“EFFECTIVENESS OF HEDGING AND HEDGE

RATIO ESTIMATION”
Submitted in partial fulfillment of the requirement for MBA
Degree of Bangalore University
BY
Shivaraj.G
Registration Number
04XQCM6086
Under the guidance of
Prof.B.V.Rudramurthy
M.P.Birla Institute of Management

Associate Bharatiya Vidya Bhavan
Bangalore-560001
2004-2006
M.P.BIRLA INSTITUTE OF MANAGEMENT

DECLARATION
I hereby declare that the research project titled “EFFECTIVENESS OF

HEDGING AND HEDGE RATIO ESTIMATION” is prepared under the guidance of
Prof.B.V.Rudramurthy in partial fulfillment of MBA degree of Bangalore University,
and is my original work.
This project does not form a part of any report submitted for degree or diploma
under Bangalore University or any other university.
Place: Bangalore Shivaraj.G

PRINCIPAL’S CERTIFICATE
This is to certify that Mr. Shivaraj.G, bearing Registration No:
04XQCM6086 has done a research project on “EFFECTIVENESS OF HEDGING
AND HEDGE RATIO ESTIMATION” under the guidance of
Prof.B.V.Rudramurthy M.P. Birla Institute of Management, Bangalore. This has not
formed a basis for the award of any degree/diploma for any other university.
Place: Bangalore Dr.N.S.MALLAVALLI
Date: PRINCIPAL
MPBIM, Bangalore

GUIDE’S CERTIFICATE
I hereby declare that the research work embodied in this dissertation
entitled “EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION”
has been undertaken and completed by Mr.Shivaraj.G under my guidance and
supervision.
I also certify that he has fulfilled all the requirements under the covenant
governing the submission of dissertation to the Bangalore University for the award of
MBA Degree.
Place: Bangalore Prof.B.V.Rudramurthy
Date: Research Guide
MPBIM, Bangalore

ACKNOWLEDGEMENT
The successful accomplishment of any task is incomplete without acknowledging
the contributing personalities who both assisted and inspired and lead us to visualize the
things that turn them into successful stories for our successors.
First of all I thank the Almighty God for his grace bestowed on us throughout this
project.
My special thanks to my project Guide Prof.B.V.Rudramurthy, who guided me
with the timely advice and expertise and has helped remarkably to complete the project.
Last, but not the least, I would like to thank my Parents and all my Friends for their
wholehearted direct and indirect support and encouragement.
SHIVARAJ.G

CHAPTER CONTENTS PAGE

NO.
ABSTRACT
1. INTRODUCTION:
¾ THOEORETICAL CONSIDERATIONS
2. LITERATURE REVIEW:
3. RESEARCH METHODOLOGY:
¾ PROBLEM STATEMENT
¾ OBJECTIVES
¾ SCOPE OF THE STUDY
¾ LIMITATIONS
¾ DATA AND SAMPLE OF DATA
¾ METHODOLOGY
4. DATA ANALYSIS:
¾ TEST FOR UNIT ROOT AND

COINTEGRATION.
¾ RESULTS FROM OLS.
¾ RESULTS FROM ECM.
¾ TABLES.
¾ GRAPHS.
5. CONCLUSION:
REFERENCES:

Abstract:
This research project investigates the hedging effectiveness of the NIFYT AND
CNXIT stock index futures contract using weekly settlement prices for the period April
2001 to March 2006 and August 2003 to March 2006 respectively. Particularly, it focuses
on three areas of interest: the determination of the appropriate model for estimating a
hedge ratio that minimizes the variance of returns; the hedging effectiveness and the
stability of optimal hedge ratios through time; an in-sample forecasting analysis in order
to examine the hedging performance of different econometric methods. The hedging
performance of this contract is examined considering alternative methods, i.e. Ordinary
Least Square method and Error Correction Model, for computing more effective hedge
ratios. The results suggest the optimal hedge ratio that incorporates nonstationarity, long
run equilibrium relationship and short run dynamics is reliable and useful for hedgers.
Comparisons of the hedging effectiveness and hedging performance of each model imply
that the error correction model (ECM) is superior to the other models employed in terms
of risk reduction.
In this study we have estimated the hedge ratios using both the methods and compared
both the methods, the hedge ratio obtained from the ECM is better compared to the OLS
method. And the Adjusted R-sqr measures the effectiveness of hedge ratios determined
through the OLS AND ECM methods.
Finally, the results showed that CNXIT index futures contracts are better instrument
for hedging and also on minimizing the market risk over the time. And also CNXIT index
futures contracts reveals the better adjusted R-sqr results in both the methods compared
to the NIFYT index futures contract.


Introduction.
The basic motivation for hedging is to reduce or eliminate the variability of profits and
firm value that arises from market changes. The effectiveness of a hedge becomes
relevant only in the event of significant change in the value of the hedged item. A hedge
is effective if the price movements of the hedged item and the hedging derivative roughly
offset each other.
Hedging through trading futures is a process used to control or reduce the risk of
adverse price movements. The introduction of stock index futures contracts offer the
market participants the opportunity to manage the market risk of their portfolios without
changing the portfolios composition.
Ederington (1979) defines hedging effectiveness as “the reduction in variance and

states that the objective of a hedge is to minimize the risk”. Howard and D’Antonio
(1984) define hedging effectiveness as the ratio of the excess return per unit of risk of the
optimal portfolio of the spot commodity and the futures instrument to the excess return
per unit of risk of the portfolio containing the spot position alone (see also, Pennings and
Meulenberg, 1997). Hsin et al. (1994) measure hedging effectiveness by considering both
risk and returns in hedging.
However the statement “futures contracts do not introduce risk” is not correct.
Numerous studies, which investigate measures of effectiveness, try to determine to

what extent hedgers are able to reduce cash price risk by using futures contracts. First,
Markowitz (1959) measures the hedge effectiveness as the reduction in standard
deviation of portfolio returns associated with a hedge. Then, Ederington1 (1979),
following the work of Working (1953), Johnson (1960) and Stein (1961), measures
hedging effectiveness as the percentage reduction in variability. “He explains that a
hedge is effective if the R-squared of the Ordinary Least Square regression explaining the

data is high, say 90%. But a high R-squared by itself is not always a reliable indicator of
hedging effectiveness. However a R-sqr of > 50% shall be eligible for testing.
All previous studies, which investigate measures of hedging effectiveness, use the
simple Ordinary Least Squares Regression (OLS) for estimating hedge ratios. However,
there is wide evidence that the simple regression model is inappropriate to estimate hedge
ratios since it suffers from the problem of serial correlation in the OLS residuals and the
heteroskedasticity often encountered in cash and futures price series. So, to counter the
problem of inconstant variances of index futures and stock index prices, a number of
papers measure optimal hedge ratios via autoregressive conditional heteroskedastic
processes which allow for the conditional variances of spot and futures prices to vary
over time. A second problem encountered when estimating hedge ratios arises from the
cointegrative nature between spot and futures markets. If no account is made for the
presence of cointegration it can lead to an under-hedged position due to the
misspecification of the pricing behavior between these markets.

Theoretical considerations:
S&P CNX Nifty Futures:
A futures contract is a standardized forward contract, which is traded on an

Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures
contracts are based on the popular market benchmark S&P CNX NIFTY index.
NSE defines the characteristics of the futures contract such as the underlying index,
market lot, and the maturity date of the contract. The futures contracts are available for
trading from introduction to the expiry date.
S&P CNX Nifty:

S&P CNX Nifty is a well diversified 50 stock index accounting for 25 sectors of the
economy. It is used for a variety of purposes such as benchmarking fund portfolios, Index
based Derivatives etc.
S&P CNX Nifty is owned and managed by Indian Index Services and Products Ltd
(IISL), which is a joint venture between NSE and CRISIL. IISL is India's first specialized
company focused upon the index as a core product. IISL have a consulting and licensing
agreement with Standard & Poor's (S&P), who are world leaders in index services.
The average total traded value for the last six months [from Nov 2005 to May 2006]
of all Nifty stocks is approximately 49.8% of the traded value of all stocks on the NSE
Nifty stocks represent about 56.5% of the total market capitalization as on March 31,
2006.
Impact cost of the S&P CNX Nifty for a portfolio size of Rs.5 million is 0.07%
S&P CNX Nifty is professionally maintained and is ideal for derivatives trading.

Hedging:
Hedging operations exist to reduce or eliminate risk arising from the fluctuation in the
price of the underlying asset.
To hedge something is to construct a protective fence around it. Applied to financial

markets, hedging means eliminating the risk in an asset or a liability. Applied to stock
market, hedging means eliminating the risk in a investment portfolio. Since hedging is
explained in terms of risk, let us explain what risk is.
RISK IS NOT LOSS:
It is the uncertainty of an expected future event. The uncertainty may turn out to be
favourable or unfavorable. Risk is thus a neutral concept: profit and loss are merely two
sides of the same coin called risk. Since hedging eliminates risk, it follows that hedging
shuts the door closed to profit as well as loss: the investment is locked at a particular
value, and it neither gains nor looses in value from subsequent price changes.
HEDGERS SPECULATORS
Hedgers are parties who are exposed to risk Speculators do not have a prior
because they have a prior position in the position that they want to hedge
commodity or the financial instrument against price fluctuations. They buy
specified in the futures contract. By taking an or sell futures contracts in an attempt
opposite position in the futures market, to earn a profit. Rather they willing
parties who are at risk with an asset can to assume the risk of price
hedge their position. By doing so, they can fluctuation in the hope of profiting
shield themselves against the risk of from them.
unexpected price changes.

Cross hedging:
A cross hedge is one in which the cash asset and the asset underlying the futures contract
are not identical. This situation arises when the hedger uses a futures contract with an
underlying asset different from the one he is currently long or short. For example,
consider a hedger who uses S&P 500 futures contracts to hedge against a decline in the
value of his portfolio, which is different from the 500 component stocks in the S&P 500.
Sometimes there are no available futures or market for currencies. In these cases, the risk
managers might wish to use a substitute or proxy for underlying currency that is
available. Use of proxy instrument for hedging underlying assets is known as cross
hedging
Cross hedger would like go through a simple 2 steps process to determine the optimal
cross hedge: first, find the currency futures most highly correlated with the actual
currency of exposure. Second, find the optimal hedge ratio using the covariance between
proxy futures and actual currency.
Hedging is one of the three principal ways to manage risk, the others being
diversification and insurance. Let us bring out the distinction between the three.
Diversification minimizes risk for a given amount of return. Hedging eliminates both
sides of risk: the potential profit and the potential loss: Insurance resolves risk into profit
and loss, and eliminates the loss while retaining the profit.
Diversification is affected by choosing a group of assets instead of a single asset.

Hedging is implemented by adding a negatively and perfectly correlated asset to an
existing asset. Insurance for investment is achieved by buying a put option on the

investment. Diversification and hedging do not have cost in cash but may have
opportunity cost. Insurance, on the other hand has explicit cost incurred in cash.
Index Futures in Hedging:
Index futures is the most popular and useful medium for hedging in stock market. This is
in contrast to commodity and currency markets where it is not useful. The reason is that
commodity and currencies are primarily consumed and are not substitutable with each
other. In contrast, stocks are held for investment and can be substitutable with each other.
Since the stock index comprises many stocks, it acts as a good substitute or proxy for
many investment portfolios. With one index representing the stock market as a whole, the
transaction costs will be minimal and the administrative work is lesser. This is the reason
why stocks are physical securities but do not have futures contract; and index is a
derivative and index futures is derivative on derivative. To sum up, we can use the same
index futures for hedging any investment portfolio.
As a general rule, a buy position or "long" in the underlying asset is covered by a sell
position or "short" position in futures. Conversely, a "short" position in the underlying
asset is covered by a buy position or "long" in futures.
The greater the correlation between the changes in prices of the underlying asset and the
futures contract the more effective is the hedge. As such, the loss in one market is
partially or totally compensated by the profit in the other market, given that the traded
positions are equal and opposite.
It is very important to note that hedging does not necessarily improve the financial
outcome, it just reduces the uncertainty. In practice, hedging is not perfect; because of the
basis risk which arises due to the following reasons:
i. The asset being hedged might be different than the one underlying the futures
contract, i.e. using a 30y T-bill to hedge a 10y T-note;

ii. The hedger might be uncertain about the exact time that the delivery has to take
place, i.e. a new oil ring that is expected to start extracting next summer, without
knowing exactly when; and
iii. The futures contract matures after the delivery date that the hedger has in mind,
i.e. the hedger needs to buy steel in January but steel futures expire on March.
The basis is defined as
Where S(t) is the spot price of the underlying asset and F(t,T) is the price of the futures
contract that has been utilized. If the asset to be hedged is the same as the one underlying
the futures, then the basis on expiration is equal to zero. If the delivery date is not the
same as the one that the futures matures, then the basis will signify the ``losses'' or
``gains'' of the hedge than are not known when the hedge is constructed.
Example. (Basis risk: different maturities) Today, the gold price isS(t). Say that one
has to deliver gold at time , and in order to hedge takes a short position on a futures
contract that matures at time T>t. The price of this contract is equal to F(t,T) , and the
basis today is :
.
The basis on the delivery date will be
,
Will indicate the gains [or losses] due to the hedge. See Figure.1 for a visual
representation of the basis risk.
Figure.1

Basis risk
Generally speaking, the basis risk arises from uncertainty about the future interest rates
and uncertainty about the future yields of the underlying asset. For investments that are
difficult or costly to store, the basis risk might increase substantially. The delivery month
that is as close as possible -but not earlier than, the date when the hedge matures.
In considering the use of futures contracts to hedge an established spot position the
investor must decide on the hedge ratio, h , to be employed. The hedge ratio is the ratio of
the number of units traded in the futures market to the number of units traded in the spot
market. The particular hedging strategy adopted depends crucially on the investor’s
objectives. Research has concentrated on three hedging strategies: the traditional one-to
one; the beta hedge; and the minimum variance hedge proposed by Johnson (1960) and
also associated with Ederington (1979).
The traditional strategy emphasizes the potential for futures contracts to be used to
reduce risk. It is a very simple strategy, involving the hedger in taking up a futures
position that is equal in magnitude, but opposite in sign to the spot market position, i.e. h
= -1. If proportionate price changes in the spot market matches exactly those in the
futures market, the price risk will be eliminated. However, in practice, it is unlikely for a
perfect correlation between spot and future returns to exist, and hence the hedge ratio that
minimizes the variance of returns will definitely differ from –1. Beta hedge ratio simply
refers to the portfolio’s beta.

The beta hedge has the same objective as the traditional 1:1 hedge that establishes a
futures position that is equal in size but opposite in sign to the spot position. Yet, when
the cash position is a stock portfolio, the number of futures contracts needed for full
hedge coverage needs to be adjusted by the portfolio’s beta. In many cases the portfolio
to be hedged will be a subset of the portfolio underlying the futures contract, and hence
the beta hedge ratio will deviate from –1. However, it may be the case that the futures
contract may mirror the portfolio to be hedged, and thus the beta hedge ratio will be the
same as the traditional hedge ratio.
According to Lypny and Powalla ‘the appropriateness of this criterion depends on

whether mean futures returns are zero; if they are not, hedging may be too expensive’.
Johnson (1960) proposed the minimum variance hedge ratio (MVHR) as an alternative
to the classic hedge. He applied modern portfolio theory to the hedging problem. It was
the first time that definitions of risk and return in terms of mean and variance of return
were employed to this problem. Johnson maintained the traditional objective of risk
minimization as the main goal of hedging but defined risk as the variance of return on a
two-asset hedged portfolio. The MVHR (h*) is measured as follows:
cov(ΔS,ΔF)
h* =
var(ΔF)
Where,
F and S represent the relative amount invested in futures and spot respectively,
cov(ΔS,ΔF) is the covariance of spot and futures prices changes, and var(ΔF) is the
variance of futures price changes. It should be mentioned that the minimum variance
hedge is the coefficient of the regression of spot price changes on futures price changes.
The negative sign reflects the fact that in order to hedge a long stock position it is
necessary to go short (i.e. sell) on futures contracts. Using the MVHR assumes that
investors are infinitely risk averse. While such an assumption about risk-return trade-off

is unrealistic, the MVHR provides an unambiguous benchmark against which to assess

hedging performance.

LITERATURE REVIEW:
1. DIMITRI KENOURGIO: “HEDGE RATIO ESTIMATION AND HEDGING

EFFECTIVENESS: THE CASE OF THE S&P 500 STOCK” market index futures
contract:
[Department of Economics, University of Athens, 5 Stadiou Street, Office 115,
10562 Athens, Greece]
This paper investigates the hedging effectiveness of the Standard & Poor’s
(S&P) 500 stock index futures contract using weekly settlement prices for the period
July 3rd, 1992 to June 30th, 2002. Particularly, it focuses on three areas of interest: the
determination of the appropriate model for estimating a hedge ratio that minimizes the
variance of returns; the hedging effectiveness and the stability of optimal hedge ratios
through time; an in-sample forecasting analysis in order to examine the hedging
performance of different econometric methods. The hedging performance of this contract
is examined considering alternative methods, both constant and time-varying, for
computing more effective hedge ratios. The results suggest that the optimal hedge ratio
incorporates nonstationary, long run equilibrium relationship and short run dynamics is
reliable and useful for hedgers. Comparisons of the hedging effectiveness and in-sample

hedging performance of each model imply that the error correction model (ECM) is
superior to the other models employed in terms of risk reduction.
Methodology:
This paper aims to determine the appropriate model when estimating optimal hedge
Ratios. The alternative models employed are the following:
Model 1: The Conventional Regression Model:

This model is a linear regression of change in spot prices on changes in futures
Prices. Let St and Ft be logged spot and futures prices respectively, the one period
MVHR can be estimated as follows:
ΔSt = a + β · ΔFt + u(t)
Where u(t) is the error from the OLS estimation, ΔSt and ΔFt represent spot and futures
Price changes and the slope coefficient β is the optimal hedge ratio (h*).
Model 2: The Error Correction Model:

Engle and Granger (1987) stated that if sets of series are cointegrated, then there
exists a valid Error Correction Representation of the data. Thus, if St represents the
index spot price series and Ft the index of futures price series and if both series are I
(1), there exists an error correction representation of the following form:
ΔSt = aut + · ΔFt + Σ · ΔFt k + Σ · ΔS + e
where ut-1 = St-1 – [a0 + a1Ft-1] is the error correction term and has no moving average
part; the systematic dynamics are kept as simple as possible and enough lagged
variables are included in order to ensure that et is a white noise process; and the
coefficient β is the optimal hedge ratio.
Model 3: The GARCH Mode:l

A useful generalization of ARCH models introduced by Bollerslev (1986) is the

GARCH model, that parameterizes volatility as a function of unexpected information
shocks to the market. The equation for GARCH is the following:
…………(1)
The equation specified above is a function of three terms: the mean α0, news about
volatility from the previous period, measured as the lag of the squared residual from the
mean equation e^2t-1 (the ARCH term), and last period's forecast variance σ^2t-1 (the
GARCH term). The more general GARCH (p, q) calculates σ^2t from the most recent p
observations on e^2 and the most recent q estimates of the variance rate.
Estimation sometimes results in: a1 + β ≈ 1, or even α1 + β > 1. Value of α1 + β close
to unity implies that the persistence in volatility is high. In other words, in order to
intercept expression (1), suppose that there is a large positive shock et-1, and hence e^2t-1
is large, then thee conditional variance σ^2t increases.
Model 4: The EGARCH Model
Where ϖ, α, β, ϒ are constant parameters. The left- hand side is that of the conditional
variance. This implies that the leverage effect is exponential, rather than quadratic, and
that forecasts for the conditional variance are guaranteed to be nonnegative. Since ,
the is included, the model will be asymmetric if ϒ ≠ 0. the presence of leverage
effects can be tested be the hypothesis that ϒ > 0. if the leverage effect term ϒ, after

running the appropriate regression, is negative and statistically different from zero, this
will imply that positive shocks generate less volatility than shocks(bad news).
Comparisons are then made of the hedging effectiveness associated with each hedging
strategy based on the minimum variance hedge ratio estimations, using the simple OLS,
the ECM, the ECM with GARCH errors and the GARCH and EGARCH models. The
question of the appropriate model to use when estimating the optimal hedge ratio of the
S&P 500 index futures contracts traded in the US is of considerable interest to investors
wishing to use this contract for hedging
In addition, comparisons of in-sample hedging performance between the four models

are given. Investors are usually concerned with how well they have done in the past.
Therefore, the in-sample hedging performance is a sufficient way to evaluate the hedging
performance of alternative models employed to obtain the optimal hedge ratio. The
measures that are most used to identify how well individual variables track their
corresponding series are the Root Mean Square Errors (RMSEs), Mean Absolute Errors
(MAEs) and Mean Absolute Percent Errors (MAPEs).
Finally, the issue of the stability of the estimated hedge ratio is also examined in this
study using the Chow’s breakpoint test for the superior model. They apply the Chow’s
breakpoint test by examining parameter consistency from 19/3/1999 onwards.
Conclusions:
This paper estimated optimal hedge ratios and examined the hedging effectiveness of
the S&P 500 index using alternative models, both constant and time-varying, over the
period from July 1992 to June 2000. The findings of this study suggest that in terms of
risk reduction the error correction model is the appropriate method for estimating optimal
hedge ratios since it provides better results on both slope as well as adjusted R-sqr in
comparison with the conventional OLS method, the ECM with GARCH errors, the
GARCH model, and the EGARCH model.

The evidence presented in this paper strongly suggests that the S&P 500 stock index
futures contract is an effective tool for hedging risk. This is consistent to earlier studies
on S&P 500 index covering the 1980s and early 1990s. Hence, the introduction of this
contract has given portfolio managers and investors a valuable financial instrument by
which they can avoid risk at times they wish to do this without liquidating their spot
position or changing their portfolios composition.
2. CHRISTOS FLOROS+ and DIMITRIOS V. VOUGAS:

HEDGING EFFECTIVENESS IN GREEK STOCK INDEX FUTURES MARKET:
[Department of Economics, University of Portsmouth, Locksway Road, Portsmouth, PO4
8JF, UK.]
This paper examines hedging effectiveness in Greek stock index futures market. It
focus on various techniques to estimate variance reduction from constant and time-
varying hedge ratios. For both available stock index futures contracts of the Athens
Derivatives Exchange (ADEX), they employ a variety of models to derive and estimate
the effectiveness of hedging.
It measure hedging effectiveness using three different methods: (i) the OLS method,
(ii) the method of minimum variance hedge ratio, Ederington (1979), and (iii) the method
suggested by Park and Switzer (1995) where ,
σ^2(Unhedged) – σ^2(hedged)
HE = ______________________________
σ^2(Unhedged)

. In both cases for Greek stock index futures, the hedge ratio from M-GARCH model
provides greater variance reduction, in line with similar findings in the literature. These
findings are helpful to risk managers dealing with Greek stock index futures.
Methodology:
Different measures of hedging effectiveness include the early measure of Markowitz

(1959), the method of Ederington (1979), the measures of Howard and D’Antonio (1984,
1987), and the Lindahl’s (1991) measure.
An early measure of hedge effectiveness comes from Markowitz (1959). He measures
hedging effectiveness in accordance with the reduction in standard deviation of portfolio
returns associated with a hedge. In this case, the greater reduction in risk, the greater is
the hedging effectiveness.
ΔS = c + bΔF + u
He shows that a hedge is effective if the R-squared of the regression line explaining
the data is high. In other words, the higher the R-squared, the greater the effectiveness of
the minimum variance hedge.
However, the effectiveness of the minimum-variance hedge can be determined by
examining the percentage of risk reduced by the hedge (Ederington, 1979; Yang, 2001).
Hence, the measure of hedging effectiveness is also defined as the ratio of the variance of
the unhedged position minus the variance of the hedged position, over the variance of the
unhedged position.
σ^2(Unhedged) – σ^2(hedged)
HE = ______________________________
σ^2(Unhedged)
It compares the measures of hedging effectiveness using several types of Hedging

models. Since the selection of the measure of hedge effectiveness has a considerable
impact on the assessment of hedged portfolios, they measure hedging effectiveness of

Greek stock index futures markets using Model (1), Model (2) and Model (3). To do so,
the hedge ratios obtained from the methods of OLS, ECM, and BGARCH are considered.
Conclusion:
In this paper they investigate the hedging effectiveness of Greek stock index
futures contracts. (FTSE/ASE-20 and FTSE/ASE Mid 40). To do so, they compare
several techniques of measuring hedging effectiveness. In particular, they measure
hedging effectiveness of Greek stock index futures markets using three different
methods: (i) the OLS model, (ii) the measure of hedging effectiveness which is defined as
the ratio of the variance of the unhedged position minus the variance of the hedged
position, over the variance of the unhedged position, and(iii) the method suggested, and
applied, by Park and Switzer (1995) and Kavussanos and Nomikos (2000).
The primary objective of this paper is to examine whether the hedge ratios calculated
from several methods generate better results in terms of hedging effectiveness To do so,
the hedge ratios obtained from these methods of OLS, ECM, and BGARCH are
considered.
First, the results from the OLS model show that the R-sq. value of FTSE/ASE-20 is
much higher than that of FTSE/ASE Mid 40. Therefore, the FTSE/ASE-20 index
provides larger risk reduction. Furthermore, the second method indicates that the
FTSE/ASE-20 contract produces the most effective hedges. In this case, for both
contracts the OLS hedge ratio provides greater variance reduction. Then, following the
papers of Park and Switzer (1995) and Kavussanos and Nomikos (2000), we show that
the BGARCH hedge ratio provides greater variance reduction than the other models. So,
the hedge ratio obtained from the Bivariate cointegration GARCH model generates better
results in terms of hedging effectiveness. This is in accordance with Park and Switzer
(1995), Kavussanos and Nomikos (2000) and Yang (2001). Finally, they measure the
hedging effectiveness by considering the hedging performance for the post-sample
periods. Using forecasting statistics for OLS model and ECM, they find that the root
mean squared error of ECM is lower than that of OLS for both indices. Hence, the ECM

outperforms the OLS (conventional) model, and therefore, the error correction model
(ECM) is superior to the conventional model. This is consistent with Chou et al. (1996).
3. STEPHEN FIGLEWSKI : HEDGING PERFORMANCE AND BASIS RISK IN

STOCK INDEX FUTURES: (1984) Journal of Finance . Vol. 39. (657-669).
According to STEPHEN FIGLEWSKI the return and risk for an index futures hedge will
depend upon the behavior of the “ basis” i.e. , the difference between the futures price
and the cash price.
In general basis risk arises simply because the connection between the futures market
and the cash market is imperfect, except at maturity of the futures contract.
Basis risk can arise from a number of different sources and is a more significant problem
for stock index co tracts than for other financial futures, like treasury bills and bonds. The
most apparent cause of basis risk is the nonmarket component of return on the cash stock
position.
In this paper they examine the basis and the different sources of basis risk on the
Standard and Poor’s 500 index contracts.
Methodology:
In this paper they have used constant hedge ratio and variable hedge ratio.

h* = σpf/σ^2f
To examine how effective stock index futures hedges would have been in reality, they
have calculated the risk and return combinations which could have been achieved by
selling standard and Poor’s 500 futures against the underlying portfolio of five major
stock indexes over one week holding periods.
To examine the dynamic of the basis, they ran regression of the change in the basis on the
deviation from the theoretical value and the change in the spot index.
Conclusion:
Finally, they have observed that, a more effective hedge may be achievable with a more
specialized instrument, such as industry group index futures. Another observation was
that the risk minimizing hedge ratio was in all cases smaller then the beta of the portfolio
being hedged, contrary to what has been suggested elsewhere.
In considering the sources of basis risk in a hedge of the S&P portfolio itself, they
found that dividend risk was not an important factor, while hedge duration and time to
expiration of the futures contract were, to some extent. One day hedges were subject to
substantially more basis risk than one week hedges, but there did not seem to be any
further improvement for extending the holding period to four week.
They found other evidence indicating that the character of the futures market has changes
over time in the fact that the speed of adjustment of the actual futures price toward the
theoretical level has increased. At present about 70 percent of a discrepancy is eliminated
in one day. Overall evidence points to the conclusion that the stock index futures market
is now fairly efficient and becoming more so with time.

4. HOLBROOK: NEW CONCEPTS CONCERNING FUTURES MARKETS AND

PRICES: Working paper by. American Economic Review , Vol 52, (431-459)
According to Holbrook research on futures markets during last 40 years has produced
results that have required drastic revision or replacement of a great part of the previously
accepted theory of futures markets and of the behavior, not only for futures prices, but of
the general class of prices behavior of businessmen including speculators, and on the
functioning of the price system.
Empirical research has played a leading role in the advancement of economic knowledge
and understanding that is described here, but the role has been a different one than
economist have ordinarily thought that such research would play in advancing their
science.
The hedging market concept:

Futures markets have usually been regarded, in the past, as essentially speculative
markets. Although they rather early won recognition as useful for hedging, their hedging
use was treated as a fortunate by-product, neither necessary to the existence of such a
market, nor very closely related quantitatively to the amount of speculation on the
market.

Irwin undertook a study of the origins of futures markets in butter and eggs. Taking
advantage of the fact that there were then people still alive who had witnessed the early
stages of emergence of futures markets came from hedgers rather than from speculators.
The multipurpose concepts of hedging:
According to the traditional concepts, hedging consists in matching one risk with an
opposing risk , and hedging in futures is effective because changes in spot prices of a
commodity tend to be accompanied by like changes in the futures price. The fact that
hedging usually involves more than risk avoidance has been known to hedgers
themselves and to some economists.
Quantitative studies, perhaps surprisingly, have contributed more to understanding of
hedging than have verbal inquires concerning business motivation. Particularly
noteworthy among these were studies of the quantitative relation between hedged
stockholding and market “carrying charges “, which brought recognition that much
hedging was done to assure profits, not merely to avoid risk
The traditional hedging concept represents the hedger as thinking in terms of possible
loss from his stockholding being offset by gain on the futures contracts held as a hedge ,
the carrying-charge hedger thinks rather in terms of change in “basis” , that is, change in
the spot futures price relation.

5. JERPME L. STEIN:
THE SIMULTANEOUS DETERMINATION OF SPOT AND FUTURES PRICES:
Working paper: American Economic Review, Vol. 51 (1012-1025)
This paper develops a simple geometric technique for the simultaneous determination
of spot and futures prices in commodity markets:
The decision to hold hedged and unhedged stocks under pure competition:
Unhedged holding of stocks:

The expected gain from holding unhedged stocks is equal to the spot price expected to
prevail at a later date (p*) minus the current spot price (p) minus the marginal net
carrying costs (m). There are two components of the marginal net carrying costs: the
marginal costs of storage and the marginal convenience yield, the later have a negative
element in carrying cost. The concept of the marginal convenience yield has been
developed by Brennan and Telser.
The variable p* is a stochastic variable. There is a probability that a capital loss will be
made on the holding of unhedged stocks.
Expected capital loss will be p*-p-m

The holding of hedged stocks:

When stocks are hedged, the owner incurs a liability of offset his holding of assets
(stocks). His liability is the sale of a futures contract, for the delivery of one of several
grades of a commodity sometime within the period of the futures contract.
The owner of hedged stocks does not intend to deliver a physical commodity in
fulfillment of his futures contract, but intends to repurchase a futures contract at the time
that he sells his inventory of stocks/ the expected gain from holding hedged stock is equal
to the expected gain from holding unhedged stocks minus the expected loss involved in
the sale and purchase of a futures contract.
The expected gain from holding hedged stocks is h,

h = (p*-p) - (q*-q) – m.
where ,
q is current price of futures contract
q* is price of the futures contract expected at a later date.
The optimum combination of hedged and unhedged stocks:
An owner of stock, for sale at an uncertain price, is assumed to allocate his holding
between hedged and unhedged stocks so as to maximize his expected utility. The method
of optimizing developed here is based upon James Tobin’s theory of liquidity preference.
As the portion of unhedged stock varies between zero and 100 percent, the expected
return per unit of stock varies from h to u. Risk is inherent in each form of stockholding,
where risk is defined as the situation whereby the owner may fail to receive his expected
return. Tobin used the standard deviation of the expected returns as his measure of risk.
Since he assumed that the probability density functions are symmetrical, a high standard
deviation or variance means a high probability of both negative and positive deviations
from the mean.


1. STATEMENT OF RESEARCH PROBLEM:
Market risk i.e. systematic risk of the portfolio can be reduced through
hedging. Hedging activity involves finding out of optimum hedge ratio and testing
hedge ratios. Hedging through trading futures is a process by which adverse price
movements can be controlled and reduced.
2. OBJECTIVES OF STUDY:
¾ Minimization of Market Risk through hedging.
¾ To test the Effectiveness of Hedging by different models.
¾ To find optimum hedge ratios.
The above objectives are explained in brief as follows:

A portfolio is exposed to two kind of risks i.e. market risk and non market risk. One
can eliminate non market risk by creating an optimal portfolio. The problem is reduction
of market risk. Hence in this study we try to minimize the market risk by entering into
futures market with an appropriate hedge ratio. Our objective is to minimize the market
risk which is inevitable.
Hedging provides risk reduction facility and by choosing appropriate hedge ratio one
can protect their portfolio from the market risk. In our study we are testing the
effectiveness of the hedge ratios generated by different models and see whether the
hedge ratios generated by different models give optimal position.
SCOPE OF THE STUDY:
A hedge using index futures removes the risk arising from market moves and leaves
the hedger exposed only to the performance of the portfolio relative to the market.
Futures contracts enable market participants to alter risks, which they face caused by
adverse and unexpected price changes. Hedging through future market is advantageous
because of its low cost.
This study is useful for those who are risk avers and those who wants to protect
themselves from the risk arising from the unexpected market movements. The study also
focuses on the effectiveness of the hedged portfolio and tests its effectiveness. The return
from the unhedged portfolio is exposed to unlimited market risk. However by hedging
the portfolio with appropriate hedge ratios one can minimize the unexpected market
moves.
DATA AND SAMPLE OF DATA:

The data employed in this study comprises of 260 weekly observations on the
NIFTY stock index and stock index Futures contracts( 2001-2006) and 260 observations
on the CNXIT and stock index futures contracts(2003 Aug-2006 Mar).
Closing prices of spot indices are obtained from the www.yahoofinance.com
website and prowess Database, closing prices of futures contracts are obtained from
(www.nseindia.com).
The NIFTY index comprises of 50 Indian companies, quoted on the NATIONAL

STOCK EXCHANGE (NSE), selected from various sectors, while the CNXIT
comprises of 20 Companies, that have more than 50% of their turnover from IT related
activities like software development, hardware manufacture, vending, support and
maintenance.
Futures contracts are quoted on the NATIONAL COMMODITY AND DERIVATIVE
EXCHANGE.
NIFTY futures and CNX IT futures contracts have a maximum of 3-month trading
cycle - the near month (one), the next month (two) and the far month (three).
With effect from 28th May 2004 the Base value of CNXIT has changed from 100 to
100, to account for the above change in Base value, slicing technique has been adapted.
We have confined the analysis to the near month contract because preliminary research
showed that there was no much difference between the hedging properties of the nearest
and second contract. Also nearly all trading volume is in the near month so that liquidity
is much greater in that contract.
Weekly data are preferred in this study for several reasons. First, the choice of weekly
hedges is realistic and implies that hedgers in the market rebalance their futures positions
on a weekly basis. Second, the one week hedge can be used to reduce risk without
incurring excessive transactions costs.

Finally, the weekly hedging horizon is the most common choice of the prior empirical
studies in several derivatives markets. In all estimations the futures contract nearest to
expiration is used. In line with previous studies changes in logarithms of both spot and
futures price are analyzed, and no adjustment is made for dividends.
SAMPLE:
From the past 5 years data we have taken only weekly observation on the NIFTY
and NIFTY futures, 3 years CNXIT and CNXIT futures contracts.
NIFTY contains 50 India companies with large market capitalization and CNXIT
contains 20 companies which are into IT related activities.
In this study we have taken last 5 years closing prices of NIFTY and NIFTY INDEX
FUTURES CONTRACT and also CNXIT and CNXIT futures contracts.
PERIOD OF STUDY AND SOURCE:
In this study we have adopted 5 years weekly closing prices of NIFTY and NIFTY
futures contract, and 3 years for CNXIT and CNXIT index futures contract.
SOURCES: secondary data

1. www.nseindia.com
2. www.yahoofinance.com
3. Prowess Database.
4. Capital Line Plus.

METHODOLOGY:
Test of Stationary:
Ho: Series of Data are non stationary or series has unit root (ρ = 0)
H1: Series of Data are stationary or series does not have unit root (ρ < 1.)
Test of unit root:
The existence of unit roots is firstly tested using the Augmented Dickey-Fuller test
(ADF) (Dickey and Fuller, 1981) through the following relationship:
Δ St = α + βT + ρSt-1 + ΣγΔSt-1 + Ựt
Where ΔSt = St –St-1 , St is the index of the spot market, and k is chosen so that the
deviations ut to be white noise. The same relationship is used to determine the order of
the futures price index ( Ft ).

α = constant, β = slope, T= trend, ρ = rho, γ = gamma, Ựt-1 = error term.
Cointegration:
Evidence of price changes in one market generating price changes in the other market
so as to bring about a long-run equilibrium relationship is given below:
Ft – δ0 – δ1St = εt
Where Ft and St are contemporaneous futures and cash prices at time t; δ1 and δ0are
parameters; and εt is the deviation from parity. If Ft and/or St are nonstationary then
the Ordinary Least Square (OLS) method is inappropriate because the standard errors are
not consistent. This inconsistency does not allow hypothesis testing of the cointegrating
parameter δ1. If t F and t S are nonstationary but the deviations, εt , are stationary, Ft and
St are cointegrated and an equilibrium relationship exists between them (Engle and
Granger, 1987). For Ft and St to be cointegrated, they must be integrated of the same
order. Performing unit root tests on each price series determines the order of integration.
If each series is nonstationary in the levels, but the first differences and the deviations εt
are stationary, then the prices are cointegrated of order (1,1), denoted CI (1,1), with the

cointegrating coefficient δ1 . In order to test for cointegration, two econometric

procedures are implemented: the Engle-Granger two-step methodology (Engle and
Granger, 1987) and the Johansen’s Maximum Likelihood approach (Johansen, 1988 and
1991).
According to Engle and Granger, two basic steps are followed:

1. Testing the existence of unit roots (integration order) in each index, following
Augmented Dickey-Fuller (ADF) test through equation.
2. Cointegration testing between stock index spot and futures market. Consider
prices (in log) in spot market i and futures market j ( Sti and Ftj), and Pt is the vector that
consist of Sti and Fti. According to Engle and Granger (1987), Sti, is said to be integrated
of order d, denoted Sti – 1 (d), if the dth difference of Sti, is stationery. The vector pt is said
to be cointegrated of order d, and there exists a non-zero vector δ such that δ Pt is

integrated of order d-b, for b>0. If both Sti and Fti are I(1) and Pt-(CI(1,1), [ i.e. δ, Pt-I(0)]
, then there are error-correction equations in the following form:
ΔSti = α1 [St-1i-δ1 Ft-1j] + lagged (ΔSti and ΔFtj) + ε ti
ΔFtj = α2 [Ft-1j-δ2 St-1i] + lagged (ΔSti and ΔFtj) + ε tj

Where α1 and α2 are non-zero coefficients and εti and εtj are stationery, possibly
autocorrelated error terms. Engle and Granger proposed several cointegrateion tests:
however, the most preferable is the ADF statistic test.
R^2 measures the proportion of the total variation in y explained by the linear
combination of the regressors. The coefficients of determination express the proportion of
the total variation that has been explained or the relative reduction in variance when
measured about the regression equation rather than about the mean of the dependent
variable. if the value of r = 0.9 , R^2 will be 0.81 and this would mean that 81% of the
variation in the dependent variable has been explained by the independent variable
It is usually advisable to underhedge as your confidence in the future correlation between
ΔSt and ΔFt declines: that is , as the value of R^2 declines, trade fewer contracts than the
number called for by h*. If R^2 is below some arbitrary value, perhaps 0.5 , then it is
probably not wise to use that particular futures contract to hedge at all.
1 . ORDINARY LEAST SQUARE METHOD:
The method of ordinary least square is attributed to Carl Friedrich Gauss, a German
mathematician. This method is the cornerstone of most econometric theory. It makes 10
assumptions for two-variable regression.
1. Linear Regression model: The regression model should be linear in the

parameters, as shown:
Yi = β1 + β2Xi + Ụi
Conditional expectation of Y , E(Y/Xi), is a linear function of the parameters,

the β’s . Hence linear regression will always mean a regression that is linear in the
parameters: the β’s . it may or may not be linear in the explanatory variables, the X’s.

2. X values are fixed in repeated sampling: values taken by the regressor X are
considered fixed in repeated samples. More technically, X is assumed to be
nonstochastic.
The regression analysis is conditional regression analysis that is conditional on
the given values of the regressor X.
3. Zero mean value of disturbance Ụi : given the value of X, the mean, or

expected, value of the random disturbance term Ụi is zero. Technically, the
conditional mean value of Ụi is zero. Symbolically,
E(Ụi/Xi) = 0
This assumption states that the mean value of Ụi, conditional upon the given Xi,
is zero. The assumption E(Ụi/Xi) = 0 implies that E(Yi/Xi) = β1 + β2Xi. Therefore two
assumptions are equivalent.
4. Homoscedasticity or equal variance of Ụi: given the value of Xi, the variance
of Ụi is the same for all observations. That is, the conditional variances of Ụi are
identical. symbolically, we have
var (Ụi/Xi) = E[Ụi - E(Ụi/Xi)]^2

= E[Ụi^2/Xi]
= σ^2
5. No autocorrelation between the disturbances. given any two X values, Xi, and
Xj, the correlation between any two Ụi and Ụj is zero. symbolically we have

Cov (Ụi, Ụj/Xi,Xj) = E{[Ụi - E(Ụi)]/Xi}{[Ụj - E(Ụj)]/Xj}
= E(Ụi/Xi)(Ụj/Xj)
= 0
6. zero correlation between Ụi and Xi, or E(Ụi Xi) = 0
Cov (Ụi, Xi) = E[Ụi - E(Ụi)][Xi - E(Xi)]
= E[Ụi(Xi - E(Xi))] since E(Ụi) = 0
= E(ỤiXi) - E(xi)E(Ụi)
= E(ỤiXi)
= 0
7. The number of observations n must be greater than the number of parameters

to be estimated. Alternatively, the number of observations n must be greater than the
number of explanatory variables.
8. Variability in X values: the X values in a given sample must not all be the same.
Technically, var(X) must be a finite positive number.
9. The regression model is correctly specified. Alternatively, there is no

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

10. There is no perfect multicollinearity. That is there are no perfect linear

relationships among the explanatory variables.
This model is just a linear regression of change in spot prices on changes in futures
prices. Let St and Ft be logged spot and futures prices respectively, the one period
MVHR can be estimated as follow;
ΔSt = a0 + β.ΔFt + ưt
Where ưt is the error from the OLS estimation, ΔSt and ΔFt represent spot and futures
price changes and the slope coefficient β is the hedge ratio (h*).
ERROR CORRECTION MECHANISM: (ECM)
The error correction mechanism first used by Sargan and later popularized by Engle and
Granger corrects for disequilibrium. An important theorem, known as the Granger
representation theorem, states that if two variables Y and X are cointegrated, then the
relationship between the two can be expressed as ECM.
ΔSt = α0 + α1ΔFt + α2ụt-1 + εt (2)
Where ụt-1= St-1[a0 + a1Ft-1] is the error correction term and has no moving average
part; the systematic dynamics are kept as simple as possible and enough lagged variables

are included in order to ensure that εt is a white noise process: and the coefficient α1 is
the optimal hedge ratio.
The above equation states that ΔSt depends on ΔFt and also on the equilibrium error
term.
LIMITATIONS:
1. Only NIFTY and CNXIT have been selected for hedging.
2. The above study is limited to 5 years data for NIFTY and 3 years data for CNXIT.
3. The above study considers the effectiveness of hedging only through two models
i.e. OLS Models and ECM model.
4. Selected scrip’s are included in both indices.
5. the above study is focused only on two indices i.e. NIFTY and CNXIT.

DATA ANALYSIS:
Test of Unit root and cointegration:
Tests for the presence of a unit root are performed by conducting the Augmented Dickey-
Fuller unit root rest under the assumption that there is no linear trend in the data
generated process
The series are tested at the 0 level and found stationery at 1% level, suggesting that the
series are stationery. The results for NIFTY, NIFTY INDEX FUTURES AND CNXIT,

and CNXIT INDEX FUTURES are reported in Table 1,2,3,4 respectively.

Diagrammatical representation of Stationarity is reported in Graphs1 and Graph 2.
Since we have identified that both our series, the spot prices (St) and future price (Ft)
of both the indices are I (0), then the presence or absence of cointegration can be
investigated by simply regressing the values of the spot asset (St) on the value of the
futures contracts (Ft). In particular a test for a unit root in the estimated residuals will
determine the presence or absence of cointegration. Table 5 and Table 6 Shows ADF test
results on residuals for both the indices. Since it shows that error term is I (0) in long run.
The results suggest that the spot NIFTY Index is cointegrated with the NIFTY Index
Futures and spot CNXIT Index is cointegrated with the CNXIT Index Futures contract.
We can easily see the cointegration of both indices with their respective index futures
contract in a graph Graph.3 and Graph 4.
Evidence in favour of a cointegrated system between weekly closing prices on the stock
index and weekly settlement prices on the stock index futures implies that both the cash
and the futures markets have a tendency to move together in the long run deviations from
equilibrium may be observed due to temporary disequilibrium forces.
RESULTS OF OLS MODEL:
FOR SPOT NIFTY AND NIFTY INDEX FUTURES:
The optimal hedge ratio from the regression equation
ΔSt = a0 + β.ΔFt + ưt
Using conventional approach is presented as follows:
ΔSt = 0.001834 + .521ΔFt + ưt

The slope coefficient β is the optimal hedge ratio. In our study it is more than 0.5 but not
close to unity hence results shows it is not highly significant. Prior research studies have
shown that, if the slope is close to unity then it is highly significant.
The Adjusted R-sqr is measure of good fit, but in out study R-sqr is 0.255 it is very less
[Table. 7].
FOR SPOT CNXIT AND CNXIT INDEX FUTURES:

The regression equation as follows:
ΔSt = 0.001388 + 0.833ΔFt + ưt
The slope coefficient β is the optimal hedge ratio for CNXIT INDEX. In this study it is
near to unity hence it is significant. And adjusted R-sqr is 0.684 indicates good fit
[Table 8].
Comparison of hedge ratios and adjusted R-sqr for both NIFTY AND CNXIT are found
in [Table 11].
Both, the hedge ratio and adjusted R-sqr for CNXIT are greater then NIFTY, which
indicates better to go for CNXIT rather than NIFTY in case of hedging. And R-sqr
suggests effectiveness of hedge. But if we compare our study with prior studies both the
hedge ratios are not that much effective since both R-sqr’s are below 0.8.
Prior studies suggest that R-sqr should be between 0.8 to 0.99 for effectiveness of hedge.
RESULTS OF ECM:
Since the spot NIFTY Index, spot CNXIT Index are cointegrated with NIFTY Index
futures, CNXIT Index futures respectively, then according to Engle & Granger, an ECM
must exists as presented in equation (2).
Error correction equation for NIFTY and NIFTY Index futures as follows:
ΔSt = 0.001838 + 0.492ΔFt + (-0.0004827ụt-1) + εt
Error correction equation for CNXIT and CNXIT Index futures as follows:

ΔSt = -0.000162 + 0.988ΔFt + (-0.0003307ụt-1) + εt
Table 9. And Table 10. Represents the summary of the error correction for both NIFTY
and CNXIT respectively.
By examine Table 11, we can report that the optimal hedge ratio for NIFTY is 0.492
& for CNXIT 0.988 and the error correction model for CNXIT including no lags has
good fit compared to NIFTY [i.e. CNXIT, R-sqr is 0.79 and NIFTY R-sqr is 0.674].
The error correction coefficient ụt-1 is statistically significant at level for NIFTY;
an ECM coefficient ụt-1 is significant at 5% level for CNXIT.

The comparison of hedge ratio’s determined by the two models for both indices are
presented in Table 11.
Results reveal that the data chosen for the test is significant. If we look at the t-test
values, they are highly significant at 5% level.
Comparison of t-test for both the models reveals that ECM model has highly
significant values.
And the white noise i.e. short term error term is also zero in both the indices. But
compared to NIFTY Index the CNXIT Index futures contract has greater significance is
error reduction. This we can observe in Table 11.

Conclusion:
In this report we have estimated optimal hedge ratio and examined the hedging
effectiveness of NIFTY and CNXIT Indices using OLS & ECM Models. And also we
have compared, which index gives maximum risk reduction, or effective hedge ratios.

The study has carried on NIFTY Index and CNXIT Index with their respective Futures
contracts by taking the sample data over the period of 5 years for NIFTY and 3 years for
CNXIT [April 2001 to March 2006 and 28th August 2003 to March 2006 respectively].
The finding of the study suggests that in terms of risk reduction the error correction
model is the appropriate method for estimating optimal hedge ratios compared to the
conventional OLS model.
Howard & D’Antonio define hedging effectiveness as the ratio of the excess return per
unit of risk of the optimal portfolio of the spot and the futures instrument to the excess
return per unit of risk of the portfolio containing the spot asset alone.
Here, in this study we have investigated the hedging effectiveness of NIFTY & CNXIT
by looking at adjusted R-sqr, which measures the effectiveness of the hedge.
Adjusted R-sqr for CNXIT is higher compared to NIFTY in both the models. And the
error correction model results reveals higher R-sqr value for CNXIT Index compared to
the conventional model OLS.
As per the objective of the study , to examine whether the hedge ratios calculated from
two methods generate better results in terms of hedging effectiveness or not.
CNXIT Index provides larger risk reduction compared to the NIFTY in both the
methods, and as most effective hedging tool. And also hedge ratio for CNXIT Index
generated with the help of ECM is better compared to OLS.
The results show that, the CNXIT Index futures contract is an effective tool for hedging
the risk. [I.e. hedge ratio from OLS is 0.833 and from ECM is 0.988].
To minimize or to avoid the market risk, CNXIT Index futures contracts are better
instruments as compared to the NIFTY Index futures contracts.

Table: 1
ADF Test Statistic -15.17069 1% Critical Value* -2.5735

5% Critical Value -1.9408
*MacKinnon critical values for rejection of hypothesis of a unit root.
Augmented Dickey-Fuller Test Equation

Dependent Variable: D(SPOT)
Method: Least Squares
Date: 06/10/06 Time: 19:26
Sample(adjusted): 1/08/2001 12/12/2005
Included observations: 258 after adjusting endpoints

Variable Coefficient Std. Error t-Statistic Prob.

SPOT(-1) -0.920747 0.060693 -15.17069 0.0000
R-squared 0.472371 Mean dependent var 0.000466
Adjusted R-squared 0.472371 S.D. dependent var 0.040508
S.E. of regression 0.029425 Akaike info criterion -4.210108
Sum squared resid 0.222511 Schwarz criterion -4.196337
Log likelihood 544.1039 Durbin-Watson stat 1.838292
Table:2


Date: 06/10/06 Time: 19:26
Sample(adjusted): 1/08/2001 12/12/2005
SPOT(-1) -0.920747 0.060693 -15.17069 0.0000
Table: 3


Date: 06/10/06 Time: 19:25
Sample(adjusted): 1/08/2003 7/20/2005


SPOT(-1) -1.001180 0.083844 -11.94102 0.0000
R-squared 0.519210 Mean dependent var -0.000533
Table: 4


Dependent Variable: D(FUTURES)
Date: 06/10/06 Time: 19:24
Sample(adjusted): 1/08/2003 7/20/2005
FUTURES(-1) -0.978766 0.083423 -11.73263 0.0000
Table: 5


Dependent Variable: D(RESIDUALS)
Date: 06/10/06 Time: 19:37
Sample(adjusted): 1/08/2001 12/19/2005
RESIDUALS(-1) -0.902002 0.062673 -14.39225 0.0000


S.E. of regression 40.40181 Akaike info criterion 10.23948
Sum squared resid 421134.9 Schwarz criterion 10.25321
Log likelihood -1325.013 Durbin-Watson stat 1.971213
Table: 6


Dependent Variable: D(RESIDUALS)
Date: 06/10/06 Time: 19:42
Sample(adjusted): 1/08/2003 7/27/2005
RESIDUALS(-1) -0.827192 0.086317 -9.583220 0.0000
C -0.352822 2.946443 -0.119745 0.9049
S.E. of regression 34.09559 Akaike info criterion 9.911026
Sum squared resid 153451.2 Schwarz criterion 9.954277
Log likelihood -662.0387 F-statistic 91.83810
Durbin-Watson stat 2.055444 Prob(F-statistic) 0.000000
Table: 7
RESULTS FROM ORDINARY LEAST SQUARE:

(NIFTY and NIFTY INDEX FUTURES)
-----------------------------------------------------------------------------------------------------------
Coefficients Standard Error t-Test

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

----------------------------------------------------------------------------------------------------------------------------------------------------------------
C 0.001834 0.002 1.131
ΔFt 0.521 0.055 9.447
----------------------------------------------------------------------------------------------------------------------------------------------------------------
Table: 8
RESULTS FROM ORDINARY LEAST SQUARE:

(CNXIT and CNXIT INDEX FUTURES)
-----------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------------------------------------------------
C 0.001388 0.002 0.889
ΔFt 0.833 0.049 16.914
----------------------------------------------------------------------------------------------------------------------------------------------------------------
Table: 9
RESULTS FROM ERROR CORRECTION MODEL:

(NIFTY and NIFTY INDEX FUTURES)
---------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------------------------------------------------
C 0.001838 0.001 1.712

ΔFt 0.492 0.036 13.478
υt-1 -0.000483 0.000 -18.192
----------------------------------------------------------------------------------------------------------------------------------------------------------------
Table: 10
RESULTS FROM ERROR CORRECTION MODEL:

(CNXIT and CNXIT INDEX FUTURES)
----------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------------------------------------------------------
C -0.000116 0.001 -0.091
ΔFt 0.988 0.044 22.378
υt-1 -0.000331 0.000 -8.307
----------------------------------------------------------------------------------------------------------------------------------------------------------------
Table: 11
COMPARISON BETWEEN HEDGING MODELS:
------------------------------------------------------------------------------------------------------------
NIFTY CNXIT
------------------------------------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------------------------------------------------
OLS ECM OLS ECM
Hedge Ratio 0.521 0.492 0.833 0.988

Adj. R-sqr 0.255 0.674 0.682 0.790
------------------------------------------------------------------------------------------------------------
SCOPE FOR FURTHER RESEARCH:
This study is focused only on two indices i.e. NIFYT and CNXIT. We have tested
hedge ratios by using 2 models i.e. OLS and ECM, however, further study can be
possible for testing the hedge ratios and it effectiveness with different models like
BGARCH, GARCH, VECM etc.
Glossary:
1. Basis Risk: The risk to a future investor of the basis widening or narrowing.
Relationship between the cash price of a good and the future prices of that good.
2. Cointegration: refers to co-movements in asset prices, not co-movements in
returns.
3. Hedge Ratio: The minimum number of units of a hedging instrument needed to
be held in order to minimize the overall portfolio, which is a combination of a
cash position and an hedge position.

4. Heteroscedasticity: Difference in the variance of the return over the period. or

unequal variance in returns .
5. Minimum Variance Hedge Ratio: refers as the proportion of the futures to the
cash position that minimizes the net price change risk. It indicates the number of
futures or options need to be bought or sold in order to reduce the variability of
the total hedged position to the maximum possible extent.
6. Near month contract: it is a type of futures contract likely to be matured within
a month, which is nearby in time.
7. Optimum Hedge: the hedge at which the utility of the hedger is maximized.
REFERENCES:
1. Working, H (1953), Futures trading and hedging: American Economic Review,
Vol. 43 , pg. 314-343.
2. Morkowitz, H.M. (1959), Portfolio selection: efficient diversification of
investments, JOHN Wiley and Sons, Inc., New York.
3. Stein, J.L. (1961), The simultaneous determination of spot and futures prices:
American Economic Review, Vol. 51, pg. 1012-1025.
4. Working H. (1962), New concepts concerning futures markets and prices:
American Economic Review, Vol. 52, pg. 431-459.

5. Ederington, L. H. (1979), The hedging performance of the new futures markets,

Journal of Finance, Vol.34, pg.157-170.
6. Howard,C, and D’Antonio, L. (1984), A risk-return measure of hedging
effectiveness,Journal of Financial and Quantitative Analysis, Vol.19 pg.101 -111.
7. Figlewski, S. (1984), Hedging performance and basis risk in stock index futures,
Journal of finance, Vol 39. pg. 657-669.
8. Lindahl, M. (1991), Risk-return hedging effectiveness measure for stock index
futures, Journal of futures markets, Vol. 11 , pg. 399-409.
9. Hsin, C, W., Kou, J, . and Lee, C.W. (1994), Anew measure to compare the
hedging effectiveness of foreign currency futures versus options, Journal of
futures markets, Vol. 14, pg. 685-707.
10. Park, T.H. and Switzer, L.N. (1995), Time-varying distributions and the optimal
hedge ratios for stock index futures, Applied financial economics,
Vol.5, pg.131-137.
11. Pennings, J.M.E., and Meulenberg, M.T.G. (1997), Hedging efficiency: a futures
exchange management approach, Journal of Futures Markets, Vol.17, pg.599-615.
12. Kavussanos, M.G., and Nomikos, N.K. (2000), Constant Vs. Time-varying hedge
ratios and hedging efficiency in the BIFFEX market, Transporatation research
Part E, Vol.36 pg. 229-248.
13. Chou, W.L. Denis, K.K.F. and Lee C.F (1996), Hedging with the Nikkei index
futures: the conventional model versus the error correction model, quarterly
Review of Economics and finance Vol.36, pg.495-505.

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EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION

“EFFECTIVENESS OF HEDGING AND HEDGE

M.P.Birla Institute of Management

M.P.BIRLA INSTITUTE OF MANAGEMENT

I hereby declare that the research project titled “EFFECTIVENESS OF

Place: Bangalore Shivaraj.G

M.P.BIRLA INSTITUTE OF MANAGEMENT

This is to certify that Mr. Shivaraj.G, bearing Registration No:

04XQCM6086 has done a research project on “EFFECTIVENESS OF HEDGING

AND HEDGE RATIO ESTIMATION” under the guidance of

Prof.B.V.Rudramurthy M.P. Birla Institute of Management, Bangalore. This has not

Place: Bangalore Dr.N.S.MALLAVALLI

M.P.BIRLA INSTITUTE OF MANAGEMENT

I hereby declare that the research work embodied in this dissertation

entitled “EFFECTIVENESS OF HEDGING AND HEDGE RATIO ESTIMATION”

has been undertaken and completed by Mr.Shivaraj.G under my guidance and

Place: Bangalore Prof.B.V.Rudramurthy

Date: Research Guide

M.P.BIRLA INSTITUTE OF MANAGEMENT

The successful accomplishment of any task is incomplete without acknowledging

My special thanks to my project Guide Prof.B.V.Rudramurthy, who guided me

wholehearted direct and indirect support and encouragement.

M.P.BIRLA INSTITUTE OF MANAGEMENT

CHAPTER CONTENTS PAGE

¾ TEST FOR UNIT ROOT AND

M.P.BIRLA INSTITUTE OF MANAGEMENT

M.P.BIRLA INSTITUTE OF MANAGEMENT

M.P.BIRLA INSTITUTE OF MANAGEMENT

Ederington (1979) defines hedging effectiveness as “the reduction in variance and

Numerous studies, which investigate measures of effectiveness, try to determine to

M.P.BIRLA INSTITUTE OF MANAGEMENT

M.P.BIRLA INSTITUTE OF MANAGEMENT

S&P CNX Nifty Futures:

A futures contract is a standardized forward contract, which is traded on an

S&P CNX Nifty:

M.P.BIRLA INSTITUTE OF MANAGEMENT

To hedge something is to construct a protective fence around it. Applied to financial

RISK IS NOT LOSS:

M.P.BIRLA INSTITUTE OF MANAGEMENT

Diversification is affected by choosing a group of assets instead of a single asset.

M.P.BIRLA INSTITUTE OF MANAGEMENT

Index Futures in Hedging:

M.P.BIRLA INSTITUTE OF MANAGEMENT

The basis is defined as

M.P.BIRLA INSTITUTE OF MANAGEMENT

M.P.BIRLA INSTITUTE OF MANAGEMENT

According to Lypny and Powalla ‘the appropriateness of this criterion depends on

M.P.BIRLA INSTITUTE OF MANAGEMENT

is unrealistic, the MVHR provides an unambiguous benchmark against which to assess

M.P.BIRLA INSTITUTE OF MANAGEMENT

1. DIMITRI KENOURGIO: “HEDGE RATIO ESTIMATION AND HEDGING

M.P.BIRLA INSTITUTE OF MANAGEMENT

Model 1: The Conventional Regression Model:

ΔSt = a + β · ΔFt + u(t)

Model 2: The Error Correction Model:

ΔSt = aut + · ΔFt + Σ · ΔFt k + Σ · ΔS + e

Model 3: The GARCH Mode:l

M.P.BIRLA INSTITUTE OF MANAGEMENT

A useful generalization of ARCH models introduced by Bollerslev (1986) is the

Estimation sometimes results in: a1 + β ≈ 1, or even α1 + β > 1. Value of α1 + β close

is large, then thee conditional variance σ^2t increases.

Model 4: The EGARCH Model

the is included, the model will be asymmetric if ϒ ≠ 0. the presence of leverage

Effectiveness of Hedging & Hedge Ratio Estimation

Effectiveness of Hedging & Hedge Ratio Estimation