Structurally Sound Dynamic Index Futures Hedging

Abstract

Portfolio managers use index futures for a variety of reasons. Regardless of their motivation, they will keep a close eye on the relation between the futures and their stock portfolio returns. Whenever this relation is perceived to have changed, the manager will decide whether it is worthwhile to rebalance the portfolio mix. Exact measures as to when and how much rebalancing should occur, have not yet been established. This paper proposes a heuristic algorithm to dynamically update hedged portfolios. This dynamic hedging algorithm is based on a Reverse Order Cusumsquare (ROC) testing procedure, proposed by Pesaran and Timmermann (2002), to optimally determine forecast estimation windows. In a comparison with standard alternatives (expanding window, EWLS window and rolling window), we find significant improvements in hedging performance, both in- and out-of-sampreverse order cusum-square test; index futures hedging