Effectiveness of Minimum-Variance Hedging

Abstract

Advanced electronic trading platforms and index exchange-traded funds (ETFs) have an impact on the minimum-variance hedging of stock indexes with futures. Minimum-variance hedging may provide better out-of-sample hedging performance than a naiüve futures hedge, but only in markets without active trading of ETFs or advanced electronic communications networks. There is no evidence now to suggest that complex econometric models that include, e.g., time-varying conditional covariances and error correction can improve on the simple ordinary least squares hedge ratio. In markets with actively traded index ETFs and well-established electronic trading, no significant efficiency gains are apparent from any minimum-variance hedge.

TOPICS: Mutual funds/passive investing/indexing, exchange-traded funds and applications, statistical methods