1

Estimation of the Optimal Hedge Ratio with

KLCI Futures Index

Presented by:
Tham Tzen Khai (CGA 110053)

Outline
1.0 Introduction

2.0 Literature Review

3.0 Methodology

4.0 Result & Discussion

5.0 Conclusion

1.0 Introduction

Background
Derivatives are one of the important financial instruments that investors or fund managers
use to manage one's exposure in today's increasing volatile markets.
A derivative is a financial instrument where its value is derived from the value of other
financial securities or other underlying asset as it grants a right to undertake a transaction
There are largely two categories of futures namely financial futures and commodity futures.
This thesis will study on index futures which is used to hedge against market risks of
holding equities particularly during bearish or uncertain market conditions.
FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM KLCI) Futures contract or
better known as FKLI provides and equivalent exposure to the underlying FBM KLCI
constituents.

Problem Statement
Investors and fund managers invested in Malaysia stock market are exposed to increasing risk
due to nature of increasing volatility of the Malaysia stock market especially with the recent
financial crisis. Recent study on Malaysia Futures market focused on using Malaysia Futures
for crude palm oil (FCPO) as the hedging mechanism but not Index Futures. Thus this paper
attempts to fill this limited recent academic studies in the context of Malaysia market by
investigating the hedging effectiveness of various static hedging strategies on the index futures
market. This study will then form as part of the hedging methodology for the Malaysia
investment community and also the foundation for further study for the academic world.

Research Questions
i.

What is the optimal hedge ratio for FKLI based on various static hedging methodology?

ii. How much of the variation can be reduced by the respective static hedging methodology
and derives which is a more effective method to manage KLCI index investment risks?

iii. Does the global financial credit crisis have an effect on the hedging effectiveness of the
respective static hedging methodology?

Research Objective
i.

To derive the optimal hedge ratio by comparing various static hedging methodology.

ii. To evaluate the effectiveness of hedging strategies by comparing the risk reduction of the
respective static hedging methodology and to ascertain which methodology is more
effective in managing KLCI index risks.

iii. To evaluate whether the global financial credit crisis has an effect on the hedging
effectiveness of the respective static hedging methodology.

Significance of the Study

Provide better tools to investors to access their investment portfolio in terms of risk
management and hedging with regards to Malaysia KLCI index.
The success of this model can be expanded into exchange rates, commodity market and
also interest rate market in Malaysia context.
Limited recent study has been done on the futures stock index market of emerging
economy especially Malaysia.
This study will form the foundation for other researcher to conduct further research related
to this topic given the increasing importance of the financial market of emerging countries

2.0 Literature Review

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What is Hedging and Basis Risk?

Futures markets exist primarily for hedging, which is defined as the management of price
risks inherent in the purchase or sale of commodities.
By hedging with futures, buyers and sellers are eliminating futures price level risk and
assuming basis level risk.
Usually there is a difference between the spot and the futures price which is called the
basis.
Basis risk is due to the variability in the closing basis.
The basis can either be positive or negative before the expiration day.

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Optimal Hedge Ratio & Hedging Effectiveness

One of the main concept being addressed by this study is to look at various hedging
methodologies in deriving the optimal hedge ratio (OHR).
The performance of the hedging is measured through ability to reduce the risk.
The fundamental concept of risk is link to variance of the return.
Hedging effectiveness is the percentage of variance reduction in which the hedged portfolio
will deliver.

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Researches
Author(s)

Year

Fidings

Figlewski

1984

Derives the minimum variance hedge ratio (MVHR)

and concludes that it could reduce the risk of a
diversified portfolio of large capitalized stocks by 2030% through hedging strategies.

Butterworth and
Holmes

2001

Risk reduction of 20% can be achieved based on

MVHR hedging strategy based on FTSE-Mid 250
stock index futures contract

Guo, White &

Mugera

2013

OLS, VAR and VECM method are applied to derive

the respective optimal hedge ratio. Only slight
improvement obtained based on utility
maximization method and risk reduction method.

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Researches
Author(s)

Year

Fidings

Lypny & Powalla

1998

Dynamic hedging strategy based on generalised

autoregressive conditional heteroskedasticity,
GARCH (1,1) performs better than the conventional
hedging strategy based on German stock index DAX
futures

Ahmad

2007

Dynamic hedging methodology performs better than

the traditional duration based constant ratio based
on US Treasury market.

Ku, Chen & Chen

2007

Dynamic conditional correlations (DCC) GARCH

models gives the best hedging performance
compared to conventional approach based on
Japanese & British futures market

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Researches
Author(s)

Year

Fidings

Zanottia, Gabbib
and Geranioc

2010

GARCH model produce the best hedging

effectiveness amid high volatility in the price.
Studies were done on the electricity markets namely
Nord Pool, EEX and Powernext market

Chang, La &
Chuang

2010

Hedging effectiveness of energy futures differs

significantly for bull and bear markets. Hedging
performance for crude oil and gasoline performs
better during bull market compared with bear
markets.

Bystrom

2003

OLS hedge ratio outperforms for the analysis of

hedging effectiveness of the futures contracts in
Norway.

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Researches
Author(s)

Year

Fidings

Myers

1991

GARCH model performs only marginally better than

OLS hedge ratio estimate which suggests that OLS
produce an adequate approximation.

Moosa

2003

Error correction model does not necessarily perform

better than the regular OLS model.

Sung and Sang

2010

BGARCH hedging strategies could have modest

improvements if their standard deviations are stable
and low enough. However, the magnitude of the
improvement is small where if transaction cost is
taken into account, the benefit of BGARCH over OLS
diminish.

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Researches
Author(s)

Year

Fidings

Lien, Tsui & Tsui

2002

OLS outperforms other more advance econometric

model based on FTSE 100 stock index futures

Harris, Shen and

Stoja

2007

Mix result, dynamic hedging outperforms marginally

for Euro and Pound while OLS outperforms for Yen.

Srinivasan

2011

Time varying hedging models like GARCH and ECM

does not perform better than conventional method.

Chang, Serrano
and Jimnez
Martn

2013

There is no significant differences in hedging either

the near-month or the next to near month contract
for currencies futures. Not much improvement on
hedging effectiveness based on dynamic hedging
strategy.

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3.0 Methodology

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Optimal Hedge Ratio

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.
There are the three famous hedging strategies: the traditional one-to-one, nave; the beta
hedge; and the minimum variance hedge proposed by Johnson (1960).
The fundamentals are risk is correlated to the variance of return, thus by minimizing the
variance in return will reduce the risk of the portfolio.
Hedging effectiveness (HE) is the reduction in variance of the hedge [VAR (H)] over the
variance of the unhedged position [VAR (U)]:

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Minumum Variance Hedge Ratio OLS model

It is a simple regression technique for estimating the unknown coefficients in a linear
regression model.
Coefficients are selected with the goal of minimizing the residual sum of squares.
Ederington (1979), Junkus and Lee (1985) showed the optimal hedge ratio is the same as
the slope coefficient in an Ordinary Least Square (OLS) linear regression model, of which
the return of futures prices is the independent variable and the return of spot prices the
dependent variable.

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Vector Autoregression Model (VAR)

It overcome the shortcoming of the simple regression method described above where there
exists a possibility for the residuals of the endogenous being autocorrelated.
The VAR model takes the neglected fact into consideration that the prices movements in
the past time of the stock and the futures markets do influence the current prices.
The issue of serial correlation can be addressed by applying vector autoregression.
After coming out with the equation based on VAR, the residual series are generated to
calculate the hedge ratio.
h = sf / f

where var (est) = s, var (eft) = f and cov (st, ft) = sf , all are based on the residual
series of the spot and futures market return price series.

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Vector Error Correction Model (VECM)

The drawback of VAR model is that it does not take into consideration of the possibility of
the conintegration between the spot and futures prices.
The series variances vary with time, and if the variation is related then this related time
dependent variation is called cointegration.
To overcome the shortcomings of VAR, an error-correction (EC) model based on EngleGranger specification is derived, this modes is the Vector Error-Correction Method.
VECM resolve this by adding an error correction to the error terms of each variable in the
vector autoregression to account for the long-term equilibrium relationship of spot and
futures price movements.

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Diagnostic Test

Structural Change- Chow Test

Minimize the influence of the structural change has on the model

Unit Root Test - Augmented Dickey Fuller (ADF) test

To validate whether the series are stationary where the variances and covariances are
constant over time to avoid spurious regression.

Cointegration Test - Johansens test

The existence of a cointegration relationship between two variables implies that there
is at least one causal effect running from one variable to the other.

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4.0 Result & Discussion

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Data Collection & Analysis

The data being used are both spots and futures rate to closing prices on a daily basis.
Daily returns are constructed as the first difference of logarithmic prices which help to
stabilize the variance of the volatile price series.
The dataset spans the periods from 26 August 2003 to 22 October 2013

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Index & futures Graph

2,000
1,800
1,600
1,400
1,200
1,000
800
600
03

04

05

06

07

08

FUTURES

09

10
INDEX

11

12

13

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Return Price Series ln(Futures) & ln (Index)

.08

.06
.04
.02
.00
-.02
-.04
-.06
-.08
03

04

05

06

07

08

RINDEX

09

10

RFUTURE

11

12

13

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Result of Hedge Ratio

OLS:
Pre-Crisis

Crisis

Post-Crisis

0.268434**

0.406277**

-0.012851

Note: reject H0 at * 10%, ** 5%, *** 1% significance level

VECM:
Pre-Crisis

Crisis

Post-Crisis

cov (st, ft)

2.58148 x 10-5

3.43397 x 10-5

2.9886 x 10-7

var (eft)

1.6636 x 10-4

1.2320 x 10-4

3.7454 x 10-5

Hedge Ratio

0.2269 **

0.3249 **

0.0327 **

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Result of Hedging Effectiveness (H.E)

Pre-Crisis

Crisis

Post-Crisis

VAR (U)

5.20 x 10-5

1.09 x 10-4

3.51 x 10-5

-- Nave

9.88 x 10-5

1.55 x 10-4

4.92 x 10-5

VAR(H) -- OLS

4.51 x 10-5

1.07 x 10-4

3.51 x 10-5 *

VAR(H) -- VECM 4.52 x 10-5

1.03 x x 10-4

3.52 x 10-5

H.E.-- OLS

0.132307

0.020629

~ 0*

H.E. -- VECM

0.129744

0.054218

~0

Note: * The result of hedge ratio is not significant which cascade that this result is not significant

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Discussion
VAR(H) > VAR(U) which actually increases the risk of the portfolio and thus negative

hedging effectiveness by going with nave model.

OLS model produce a better hedging effectiveness during the pre-crisis period when
compared to VECM model.
During crisis period, VECM then performs better in terms of hedging effectiveness.
There is no hedging model that is able to reduce the risk of the investment for the postcrisis period.

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5.0 Conclusion

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Conclusion
The result is mix in terms of whether OLS or VECM performs better at certain period.

Based on the hedging effectiveness performance, both methodologies perform their best
during the pre-crisis period with more than 10% in variance reduction.
Nave hedging method increases the variance hence the risk of the hedged portfolio.
There is no hedging model that is able to reduce the risk of the investment for the postcrisis period.

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