The effect of the cointegration relationship on futures hedging: A note

✍ Scribed by Lien, Da-Hsiang Donald

• Publisher: John Wiley and Sons
• Year: 1996
• Tongue: English
• Weight: 376 KB
• Volume: 16
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/(sici)1096-9934(199610)16:7<773::aid-fut3>3.0.co;2-l

✦ Synopsis

In many empirical studies, both spot and futures prices were shown to contain a stochastic trend. Consequently, it is necessary to examine the possible cointegration relationship between the two prices as suggested by the efficient markets hypothesis. The importance of incorporating the cointegration relationship into statistical modeling of spot and futures prices is well documented in the futures market literature. Hedge ratios and hedging performance may change sharply when the cointegrating variable is mistakenly omitted from the statistical model. In Lien and Luo ( 1994) it was shown that, although GARCH (Generalized Autoregressive Conditional Heteroskedasticity) may characterize the price behavior, the cointegration relationship is the only truly indispensable component when comparing ex post performance of various hedge strategies. Through empirical calculation, Ghosh ( 1993) concluded that a smaller than optimal futures position is undertaken when the cointegration relationship is unduely ignored. He attributed the underhedge result to model misspecification. This note provides a theoretical analysis to con-The research is, in part, supported by a general research grant from the University of Kansas. The author wishes to acknowledge Brad Wilson and two anonymous referees for helpful comments and suggestions. The author is solely responsible for any errors.