Summary
This paper provides the first investigation of the hedging effectiveness of the FTSE 100 and FTSE Mid 250 stock index futures contracts using hedge ratios generated within an extended mean Gini framework. This framework provides a robust alternative to the standard minimum variance approach, by distinguishing between different classes of risk aversion and producing hedge ratios that are consistent with the rules of stochastic dominance. The results show that the appropriate hedge ratio varies considerably with the investor's degree of risk aversion and that the EMG approach is capable of being utilized by all classes of risk averse investors, in contrast to the standard minimum variance approach. In addition, the results show strong evidence of a duration effect and support the use of the extended mean Gini approach when cross hedges are involved.
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The Hedging Effectiveness of U.K. Stock Index Futures Contracts Using an Extended Mean Gini Approach: Evidence for the Ftse 100 and Ftse Mid250 Contracts
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I. IntroductionTraditionally, the futures hedging literature has focused on the minimum variance (MV) approach of Stein (1961) and Johnson (1960), as extended by Benninga et al (1983), Lence (1995) and Rao (2000) among others. However, it is now well recognized that mean variance analysis is based on rather restrictive assumptions. In response to this, the extended mean Gini (EMG) approach has been proposed as an alternative framework for analyzing hedging decisions. This approach offers greater flexibility in determining the optimal hedge ratio by allowing for differentiated risk aversion, as well as being consistent with the rules of stochastic dominance.The use of the EMG approach to hedging is particularly relevant, given that it stresses the avoidance of downside risk. Hedging to avoid downside risk is one of the principal uses of index futures, through techniques such as portfolio insurance. The EMG approach has been used for investigating hedging effectiveness for a range of contracts including currency, commodity and US stock index futures. However, while U.K. stock index futures hedging has been investigated with respect to the MV approach (see Holmes [1995, 1996], Butterworth and Holmes [2000, 2001]), as yet there has been no investigation of hedging effectiveness for these contracts using the EMG approach. This is, perhaps, surprising given the importance of the U.K. markets in terms of the volume and value of trade and its international profile and is a ...See the full content of this document
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