Portfolio Hedging and Basis Risk

Publication Type

Journal Article

Publication Date

1996

Abstract

Minimum variance hedged portfolios using futures are formed by taking the linear projection of spot price changes onto futures price movements as the hedge ratio. This unwittingly assumes that the underlying spot-futures price movements follow a cointegrated process, given that the spot and the futures prices are integrated processes. If the spot-futures prices are not cointegrated, the hedged portfolio suffers from the risk of potentially large changes in its value. Empirical findings using the Nikkei stock index and the Nikkei 225 futures show this deviation in intraday trading prices. The basis movements which have often been used by intraday traders to predict future price changes, are tested to be mostly unit root processes. This is shown to be due largely to non-cointegration of the spot-futures prices, and suggests why it is profitable to trade futures using basis knowledge only if trading is done on a continual basis.

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Publication

Applied Financial Economics

Volume

6

Issue

6

First Page

543

Last Page

549

ISSN

0960-3107

Identifier

10.1080/096031096334006

Publisher

Taylor and Francis

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