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An Empirical
Authors Detail
Sanjay Kumar Thakur , PhD Student, Shailesh J. Mehta School Of Management, Indian
ABSTRACT
KEYWORDS : Hedging, Market Risk, Capital Market, Futures Market, Regression, Time-
Varying Hedging Models.
DOES MARKET VOLATILITY AFFECTS HEDGE EFFECTIVENESS? AN EMPIRICAL
1. INTRODUCTION
Risks are omnipresent and exist from time immemorial. In financial parlance, risk is any
variation from an expected outcome. So, for an investor, risk includes an outcome when one
may not receive expected return (Stein, 1961). Traditionally, hedging has been motivated by
the desire to reduce risk by taking a position opposite to the exposure. The quest for better
hedge has been the motive for sophisticated risk management and hedging techniques.
Derivatives are used as tool to transfer risk i.e for hedgers (Bodla and Jindal,2006) and,
therefore, they are extensively used as hedging instruments worldwide, including emerging
However, hedging one’s stock position through futures and options is still the road less
traveled in India. Even when it is done, the techniques used have been too naïve and
primitive. Lack of suitable hedging models for Indian market is a challenge to the risk
management system of participants and regulators. It is also a deterrent for attaining greater
market depth, and may severely affect the stability of Indian markets. Further, availability
of high frequency data in the recent past will help validate such models empirically.
1.1 MOTIVATION
Johnson (1960) has pointed out that hedgers prefer to hedge through futures market as it is
easier to square off and opt for cash settlement than taking actual delivery as is the case
with forward market, since the objective is to take advantage of relative price movements.
Hartzmark (1987) showed that hedging with futures is profitable. Evidence suggests that
futures are the most preferred choice for hedging in India. Therefore, this study focuses on
hedging price risk of equity through individual futures contracts. However, the models
used have been too naïve and primitive and based on the assumption that the price
movements are negatively correlated, and hence gains from one market offset the losses in
the other. Even National Stock Exchange of (NSE) India Ltd., whose NCFM (NSE's
discusses naïve hedging only. This study is, therefore, an attempt to explore Indian futures
market for hedging by equity holders. We reviewed the advances in HKM [Herbst, Kare
and Marshall (1993)] methodology, and compared it with JSE [Johnson (1960), Stein
(1961) and Ederington (1979)] methodology. We present a comparative study of HKM and
JSE methodology for estimating optimal hedge ratio and hedge Effectiveness for futures.
Finally, we propose to test JSE and HKM methodologies for estimating hedge
2. REVIEW OF LITERATURE
There are two main hypotheses to explain hedging. They are: (i) Destabilizing force
Destabilizing force hypothesis propounds that derivatives market attracts highly levered
and speculative participants due to lower trading costs, which creates artificial price
bubbles and increases volatility in spot market. Market completion force / non-
market and improves information flow resulting in better investment choices for investors.
It may bring more private information to the market and disseminate the same faster. Some
studies suggest a possibility of speculators moving to derivatives market from spot market
due to lower transaction costs and other benefits like cash settlement. This may lead to
reduction in volatility.
(i) impact of (launch of) futures on spot market volatility {Shenbagaraman (2002),
Hetamsaria and Swain (2003), Nagraj and Kotha (2004), Thenmozhi and Thomas (2004),
Hetamsaria and Deb (2004), Josi and Mukhopadhyay (2004), Bodla and Jindal (2006),
Bagchi (2006), Rao (2007)}; (ii) Lead-lag relationship (reflected in price and non-price
variables) between futures and spot market { Srivastava (2003), Sah and Omkarnath
(2005), Praveen and Sudhakar (2006), Mukherjee and Mishra (2006), Gupta and Singh
(2006)}; (iii) role of futures in price discovery {Sah and Kumar (2006), Gupta and Singh
(2006), Kakati and Kakati (2006)}; (iv) Impact of information and expiration effect on spot
prices {Thenmozhi and Thomas (2004), Barik and Supria (2005), Mishra, Kanan, and
Mishra (2006), Mukherjee and Mishra (2007)}, and (v) Better forecasting methods for
There is very little evidence of hedging in the Indian context. Lack of evidence on such a
markets though {Johnson (1960) and Stein (1961) in commodity market, Dale (1981), and
Herbst, Kare, and Marshall (1993) in foreign exchange market, Ederington (1979), and
Franckle (1980) in fixed income securities market.} The evidence on use of equity and
literature from commodity, foreign exchange, and fixed income securities market.
Hedge is used to reduce the risk associated with a cash position or an anticipated cash
insurance scheme for hedgers, who pay premium to speculators for taking their risk. The
basic assumption here is that hedgers are generally long in cash market and therefore, they
need to hedge their position by taking short position in forward market or future market.
In general, for a position consisting of a number, ‘Xi’ of physical units held in market “i”,
hedge may be defined as a position in market “j” of size ‘Xj*’ units such that the price risk
of holding ‘Xi’ and ‘Xj*’ from time ‘t1’ to ‘t2’ is minimized (Johnson,1960). Therefore,
Hedge ratio could be defined as the number of ‘Xj*’ units (of hedging instrument) in market
“j” required to hedge one unit held in market “i” (cash position). So, a hedger would
futures contracts. Once the underlying asset is sold, futures position may be squared off by
taking equal and opposite position (long position, in this case) in futures contract. Let ‘S1’,
and ‘S2’ denote the spot prices, and ‘F1’ and ‘F2’ the prices of futures at ‘t1’ and ‘t2’
If the change in spot price is equal to that of futures, i.e, if the price movements are parallel,
the gain from one market offsets the loss in the other. Otherwise, he would be left with a
The hedger will take a total gain (loss) arising from price movements from ‘t1’ to ‘t2’, equal
to the positive (negative) value of x [(S2, - S1) - (F2 – F1)] for ‘x’ unit of inventory.
Ö h=1
This indicates parallel shift in prices in cash and futures markets. This is one of the
spot and futures. He argued that this assumption is false, and an improper standard to test
the effectiveness of hedging. The effectiveness of hedging used with commodity storage
depends on inequalities in the movements of spot and futures prices, and on reasonable
Bt = St – h * Ft ….. (2)
In the Johnson (1960), Stein (1961), and Ederington (1979) (henceforth referred to as JSE)
methodology, spot prices are regressed on futures prices using ordinary least squares (OLS)
method.
S = a + b. F + u ….(3)
where ‘a’ is the intercept term (expected to be zero), and ‘b’, is the estimate of ‘h*’.
There are limitations of this model as mentioned by Herbst, Kare, and Marshall (1993). For
example, residuals from JSE estimation of optimal hedge ratio are serially correlated and
should be used to estimate the minimum risk hedge to account for the observed serial
differences. The merits of levels versus differences are discussed, in the context of foreign
currency hedging, by Hill and Schneeweis (1982). Another alternative is to specify the
Where, terms ‘a’ and ‘b’ are constants, ΔS = S(t) - S(t-1) and ΔF = F(t,T) - F(t-1, T) and
‘u’ represents the error term. The term ‘b’ (slope of the line) is optimal hedge ratio (with
minimum variance).
This was an improvement, though it retained some serious flaws. One of the limitations
emerged from the assumptions of regression. Regression can be used when relationship
between Explained Variable (St) and Explanatory Variable (Ft) is stable. This implies
constant basis irrespective of time of observation. In reality, in a direct hedge, the basis
must decline over the life of the futures contract and become zero at maturity. Franckle
(1980), in his reply to Enderington (1979), drew attention to this point and suggested a
modified hedge ratio that incorporates the declining basis. Castelino (1990) argued that
regression based hedge ratios must be time dependent. However, he argued that time
dependent hedge ratios can not be of minimum variance. In tests with financial futures on
short term interest rates, he claimed superior results vis-a-vis JSE by accounting for time in
the hedge ratio estimation. But his results had two limitations: (a) it is based on an arbitrage
model for treasury bonds that is of limited applicability to hedges with other futures
contracts, and (b) it implicitly relies on the stability of spot-futures relationship from the
prior year into the year of the hedge. The problem of instability of hedge ratio was also
addressed by others, such as Grammatikos and Saunders (1983), and Malliaris and Urrutia
(1991a, 1991b). However, they did not address the problems arising from the exclusion of
time.
Equation (4) suggests that the relationship is not stable but time-varying.
Where ‘a’ is the intercept term (expected to be zero), and ‘d’ (the slope), is the estimate of
‘r’. Once the coefficient of ‘T’ in Equation (6) is estimated by regression, the optimal hedge
Ö h* = edT …..(7)
An important difference between the JSE hedge ratio and that defined by Equation (7) is
that the later can be revised daily once the estimate of full cost of carry is available (from a
few trading days of a futures contract). The estimated hedge ratio ‘h*’ will change daily
depending on the term to expiration of the futures contract. The JSE hedge ratio ‘b’, on the
other hand, is a constant estimated solely from the past data. Historical data may provide
poor estimate of the minimum variance hedge ratio, especially when the spot-to-futures
However, there is confusion due to synonymous use of the terms "effectiveness" and
"efficiency''. Some of the examples include Howard and Antonio (1984), Chang and
Hedge's effectiveness may be defined as the degree to which it reduces the risk associated
with a cash position. This definition deliberately ignores the cost of hedging. A hedge is
effective if it reduces risk relative to no hedge. A hedge is efficient if there does not exist
another hedge offering greater expected profit with the same or less risk (Herbst and
Marshall, 1990). Equivalently, a hedge is efficient if there does not exist another hedge
carrying less risk with the same or greater expected profit. A hedge can be said to be
constant hedge ratio. Obviously hedge employed based on HKM Model may need more
frequent re-balancing which may increase transaction costs like commissions and cost of
personnel and technological resources. Transaction cost is not considered in our study.
However, HKM model based Hedge Ratio should be more efficient even if the hedge-
rebalancing is done less frequently as be the case with the hedge ratio based on JSE Model.
Therefore, we have estimated h* based on JSE method and HKM method on the previous
month data and hedge was employed for the next month keeping the hedge ratio constant
As Hedge effectiveness may be measured through Variation from Bases. Therefore, Bases
(actual and absolute) based on JSE and HKM model is estimated for every month and of
The lower the mean absolute basis (B), the better the hedge. Lower variance of basis means
more effectiveness.
Also, Basis (B) expressed as percentage of the average spot price will provide more clarity
3. HYPOTHESES
This study is an attempt to estimate hedge ratio and hedge Effectiveness. We have
compared JSE and HKM methodologies for estimating hedge Effectiveness using daily
nifty index data from Indian financial futures market for the period of January 01, 2005 to
July 31, 2005 and November 01, 2007 to June 30, 2009. The model with the lower estimate
(1) H0: There is no difference between the mean Bases based on JSE and HKM
methodology.
H1: Bases based on JSE methodology is greater than that based on HKM methodology .
H 0 : BJSE = BHKM
(2) H0: There is no difference between mean of bases (as % of the spot price) based on JSE and
HKM methodology.
H1 : Mean bases (as % of the spot price) based on JSE methodology is more than that based on
HKM methodology.
H 0 : % BJSE = % BHKM
hedge ratio using the two methods (JSE and HKM) h*, and the Hedge Replication (Vt)
which is estimated as ( h* x Ft) are included in table 1 and table 2 for the normal period
Table 1: Estimates of ‘h*’ and ‘Vt*’ during normal period (Year 2005)
To visually see the performance of the hedge through these two models, we have plotted
the Actual Spot price and the Hedge Replication(Vt) based on both methodology. The
better hedge is one which can replicate the actual spot price more accurately. It is clearly
visible that Vt estimated based on HKM methodology replicate then actual index value
showing that hedge ratio estimated on HKM methodology is more effective than that of
Secondly, the difference between the models, even though visibly may be small but will
2150
2100
Index Value
Nifty_Mar05
Comparative Hedge Performance
2200
2150
Index Value
Nifty_Apr05
Comparative Hedge Performance
2250
Index Value
2150
Actual Nifty Index
2050 Vt_JSE
Vt_HKM
1950
1850
27 23 21 17 15 10 8 6 2 1 0
Time to Expiry
(B)
Nifty_May05
Comparative Hedge Performance
2100
2050
Index Value
Nifty_Jun05
Comparative Hedge Performance
2350
2250
Index Value
Nifty_Jul05
Com parative Hedge Perform ance
Actual Nif ty
2450 Index
Index Value
2250 Vt_JSE
2050
Vt_HKM
1850
28 22 16 10 6 0
Tim e to Expiry
(B) VISUAL EVIDENCES DURING PERIOD OF TURBULENCE (NOVEMBER,2007-JUNE,2009)
Following are the graphs of six selected months during the period financial crisis.
6500
6400
6300
6200
6100
6000
Index Value
30
28
24
22
20
16
14
10
0
Tim e to Expiry
4000
3900
3800
3700
3600
Index Value
29
26
22
19
15
13
Tim e to Expiry
4500
4450
4400
4350
4300
Index Value
30
28
24
22
20
16
14
10
Tim e to Expiry
Nifty_Apr2009: Comparative Hedge Performance
3500
3450
3400
3350
3300
Index Value
4500
4450
4400
4350
4300
4250
Index Value
5000
4900
4800
4700
Index Value
4600
Actual Index Value
4500
Vt_JSE
4400
Vt_HKM
4300
4200
4100
4000
3900
27 24 23 22 21 20 17 16 15 14 13 10 9 8 7 6 3 2 1 0
Time to Expiry
4.2 BASES AS MEASURE OF HEDGE PERFORMANCE : A COMPARISON
The estimates of the absolute Bases and Bases as % of spot price using the two methods (JSE and HKM are included in table 4 and table 5 for
the normal period (year 2005) and period of turbulence (November,2007- June,2009).
Table 3
|BJSE| |BHKM| |BJSE| as %of Spot Price |BHKM| as %of Spot Price
Nifty Index Sum Mean Variance Sum Mean Variance Mean Max. Min Mean Max. Min
Nifty_Feb05 902.591 6.686 11.411 722.662 5.353 11.377 1.76% 3.80% 0.59% 1.41% 3.46% 0.23%
Nifty_Mar05 7818.448 57.914 203.029 2372.458 17.574 144.979 4.91% 7.25% 3.61% 1.47% 3.89% 0.12%
Nifty_Apr05 3161.494 23.418 22.514 605.326 4.484 9.669 2.81% 4.03% 1.53% 0.53% 1.48% 0.00%
Nifty_May05 427.087 3.164 3.299 330.772 2.450 5.971 0.83% 1.96% 0.00% 0.65% 2.78% 0.00%
Nifty_Jun05 1445.548 10.708 1.796 278.761 2.065 1.139 3.80% 5.07% 2.87% 0.74% 2.04% 0.00%
Nifty_Jul05 2374.071 17.586 18.434 498.655 3.694 13.527 2.42% 4.90% 1.48% 0.51% 2.95% 0.00%
Table 4
|BJSE| |BHKM| |BJSE| as %of Spot Price |BHKM| as %of Spot Price
Nifty Index Sum Mean Variance Sum Mean Variance Mean Max. Min Mean Max. Min
Nifty_Jan08 6980.881 51.710 25.303 841.621 6.234 20.018 7.74% 11.09% 6.67% 0.93% 4.52% 0.05%
Nifty_Oct08 1752.901 12.984 6.320 523.691 3.879 6.068 3.44% 5.61% 2.58% 1.03% 3.25% 0.14%
Nifty_Jul08 3145.064 23.297 13.940 461.875 3.421 16.052 5.25% 7.98% 4.27% 0.79% 3.56% 0.01%
Nifty_Apr09 546.973 3.890 14.426 526.651 1.841 0.623 0.81% 11.45% 0.03% 0.47% 10.53% 0.01%
Nifty_Sep08 4795.362 35.521 43.458 659.941 4.888 20.191 6.30% 8.60% 5.38% 0.83% 3.26% 0.00%
Nifty_Jun08 4994.616 36.997 56.032 183.084 1.356 1.385 11.31% 12.14% 9.43% 0.40% 1.56% 0.01%
Table 5 (a) : t-test Statistics
Nifty_Jan2008
t-Test: Two-Sample Assuming Unequal
Variances
Basis_JSE Basis_HKM
Mean 46.7238 3.456006
Variance 17.3216 6.46616
Observations 21.0000 21
Hypothesized Mean Difference 0.0000
df 33.0000
t Stat 40.6534
P(T<=t) one-tail 0.0000
t Critical one-tail 1.6924
P(T<=t) two-tail 0.0000
t Critical two-tail 2.0345
(1) H0: There is no difference between the mean Bases based on JSE and HKM
methodology.
H1: Bases based on JSE methodology is greater than that based on HKM
methodology .
The null hypothesis is rejected for one tail and Alternative hypothesis is accepted. This
means that Basis calculated based on JSE is greater than OHR calculated based on HKM
methodology.
Table 5 (b) : t-test Statistics
Nifty_Jan2008
t-Test: Two-Sample Assuming Equal
Variances
%_Basis_JSE %_Basis_HKM
Mean 0.0227 0.0017
Variance 0.0000 0.0000
Observations 21.0000 21.0000
Pooled Variance 0.0000
Hypothesized Mean Difference 0.0000
df 40.0000
t Stat 40.0689
P(T<=t) one-tail 0.0000
t Critical one-tail 1.6839
P(T<=t) two-tail 0.0000
t Critical two-tail 2.0211
(2) H0: There is no difference between mean of bases (as % of the spot price) based on JSE
H1 : Mean bases (as % of the spot price) based on JSE methodology is more than that
The null hypothesis is rejected for one tail and Alternative hypothesis is accepted. This
means that % Basis calculated based on JSE is greater than % Basis calculated based on
HKM methodology.
The same t-test was conducted for each months in both periods and similar results were
observed in all cases at 95% confidence level. To avoid re-peatation of similar tables, only
We have estimated hedge ratios (h*) using one month January 2005 future data and kept both
hedge ratios constant for 1 month (from January, 2005 to July, 2005) implying that hedge is
employed without re-balancing. Then we estimated bases based on these two methodology.
For the period of financial crisis (November 2007 to June 2009), we selected six most
volatile months for Nifty Index during the global financial crisis (January 2008, October
2008, July 2008, April 2009, September 2008 and June 2008) based on Volatility Index
(VIX) of National Stock Exchange of India and repeated the same exercise to estimate hedge
ratios based on both methodology and their bases to estimate the hedge effectiveness keeping
hedge ratio time-invariant throughout these months. Effectiveness of optimal hedge ratios
using HKM model are found to be significantly better for index futures at 95% confidence
level. In all cases, hedge based on HKM methodology has been found more effective than
(1) Hedge Performance based on OHR estimated on theoretically superior method (like
(2) Even after making h*HKM time-invariant, Hedge Performance based on hedge ratio
estimated on theoretically superior method (like HKM) has given superior results.
(3) Implication for Hedger : h*HKM and Basis estimated based on HKM methodology
allows a hedger to decide when to re-balance and re-balancing strategy based on Bases as 5
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