Hedging: Scaling and the Investor Horizon

TL;DR

This paper investigates whether hedge ratios derived from short-term data can be scaled for longer horizons and how their effectiveness compares to directly estimated ratios, revealing significant horizon-dependent differences.

Contribution

It demonstrates that scaling short-term hedge ratios can achieve comparable risk reduction to direct estimation across different horizons.

Findings

Hedge ratios vary significantly with the horizon.

Scaling short-term hedge ratios yields effective long-term hedging.

Direct and scaled hedge ratios perform similarly in risk reduction.

Abstract

This paper examines the volatility and covariance dynamics of cash and futures contracts that underlie the Optimal Hedge Ratio (OHR) 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 which are comparable to those based on direct estimation.