Question

why is minimum variance hedge ratio most effective

Answer 1

The debate on econometric models for estimatingthe minimum-variance futures hedge ratio hasrun for many years. Hedging commodities isan interesting econometric problem becausecarrying costs are difficult to predict, and the basis can behigh and variable, but stock indexes generally have muchlower basis risk. Nevertheless econometric models for min-imum-variance (MV) hedging of stock indexes continueto be the focus of a huge amount of empirical research.We show that minimum variance hedging only pro-vides an out-of-sample hedging performance that is supe-rior to that of the naïve futures hedge in less developedmarkets, which have no active trading of ETFs or advancedelectronic communications networks. Moreover, evenwhen minimum variance hedging does out perform anaïve hedge we find no evidence that complex econo-metric models, including time varying conditional covari-ances and error correction, can improve on the simpleordinary least squares hedge ratio.A recent strand of the literature on market microstruc-ture that relates to the impact of electronic trading on bid-ask spreads. Electronic trading reduces both humanerrors and, as smaller lot sizes become economically fea-sible, market impact. Also, given the discipline required tocommit trading rules to execution algorithms, it increasesobjectivity. Moreover, electronic trading increases liquiditybecause transaction costs are reduced.