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Volume 12 Number 2, Winter 2009/10 Research Papers Hedging: scaling and the investor horizon John Cotter
Centre for Financial Markets, School of Business, University College Dublin, Blackrock, Co. Dublin, Ireland; email: john.cotter@ucd.ie Jim Hanly
School of Accounting and Finance, Dublin Institute of Technology, Dublin 2, Ireland; email: james.hanly@dit.ie This paper examines the volatility and covariance dynamics of cash and futures contracts that underlie the optimal hedge ratio across different hedging time horizons. We examine whether hedge ratios calculated over a short-term hedging horizon can be scaled and successfully applied to longer-term horizons. We also test the equivalence of scaled hedge ratios with those calculated directly from lower-frequency data and compare them in terms of hedging effectiveness. Our findings show that the volatility and covariance dynamics may differ considerably depending on the hedging horizon, and this gives rise to significant differences between short-term and longer-term hedges. Despite this, scaling provides good hedging outcomes in terms of risk reduction that are comparable to those based on direct estimation.
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