Cross-Hedging Portfolios in Emerging Stock Markets: Evidence for the LATIBEX Index

We consider alternative possibilities for hedging spot positions on the FTSE LATIBEX Index, the index of the only international market exclusively for Latin American firms that is denominated by the euro. Since there is not a futures market on the index, it is unclear whether a relatively successful hedge can be found. We explore the plausibility of employing futures on four stock market indices: EUROSTOXX 50, S&P500, BOVESPA, and IPC, and simulate the results that could be obtained by a hedge position based on either unconditional or conditional second order moments estimated from different asymmetric GARCH models. Several criteria for hedging effectiveness suggest that futures contracts on BOVESPA should be preferred, and that a salient reduction in risk can be achieved over the unhedged LATIBEX portfolio. The evidence in favor of a better performance of conditional moments is very clear, without significant differences among the alternative GARCH specifications.

Hedging options with an illiquid underlying and non-probabilistic option pricing in practice

We compare three different dynamic hedging strategies for the purchase or sale of a bundle of European options to profit from volatility arbitrage. The investor will "cross hedge" with a stock highly correlated with the untraded underlying. The first strategy maximizes terminal utility, the second minimizes the variance of the incremental profit, and the third is the adjusted Black-Scholes strategy. We note that the nature of cross hedging results in significant potential for losses. We study the robustness of the strategies to misspecification of parameters by the investor and find that the first two strategies are more robust to parameter misspecification. On a different subject, we then attempt to find profit opportunities by pricing options using a simple non-probabilistic model. We find a situation where an investor willing to take risks can profit, but a more cautious investor cannot. We also derive basic non-probabilistic volatility arbitrage results.

Hedging options with an illiquid underlying and non-probabilistic option pricing in practice

We compare three different dynamic hedging strategies for the purchase or sale of a bundle of European options to profit from volatility arbitrage. The investor will "cross hedge" with a stock highly correlated with the untraded underlying. The first strategy maximizes terminal utility, the second minimizes the variance of the incremental profit, and the third is the adjusted Black-Scholes strategy. We note that the nature of cross hedging results in significant potential for losses. We study the robustness of the strategies to misspecification of parameters by the investor and find that the first two strategies are more robust to parameter misspecification. On a different subject, we then attempt to find profit opportunities by pricing options using a simple non-probabilistic model. We find a situation where an investor willing to take risks can profit, but a more cautious investor cannot. We also derive basic non-probabilistic volatility arbitrage results.

Dual and single hedging strategy: a novel comparison from the direct and cross hedging perspective

PurposeThe purpose of this paper is to deeply study and compare the dual and single hedging strategy, from the direct and cross hedging perspective.Design/methodology/approachThe authors not only first consider the dual hedge of integrated risks in this oil prices and foreign exchange rates setting but also make a novel comparison between the dual and single hedging strategy from a direct and cross hedging perspective. In total, six econometric models (to conduct one-step-ahead out-of-sample rolling estimation of the optimal hedge ratio) and two hedging performance criteria are employed in two different hedging backgrounds (direct and cross hedging).FindingsResults show that in the direct hedging background, a dual hedge cannot outperform the single hedge. But in the cross dual hedging setting, a dual hedge performs much better, possibly because the dual hedge brings different levels of advantages and disadvantages in the two different settings and the superiority of the dual hedge is more obvious in the cross dual hedging setting.Originality/valueThe existing literature that deals with oil prices and foreign exchange rates mostly concentrates on their relationship and comovements, while the dual hedge of integrated risks in this setting remains underresearched. Besides, the existing literature that deals with dual hedge gets its conclusions only based on a single specific background (direct or cross hedging) and lacks deeper investigation. In this paper, the authors expand the width and depth of the existing literature. Results and implications are revealing.

Hedging of Variable Annuities under Basis Risk

I study dynamic hedging for variable annuities under basis risk. Basis risk, which arises from the imperfect correlation between the underlying fund and the proxy asset used for hedging, has a highly negative impact on the hedging performance. In this paper, I model the financial market based on correlated geometric Brownian motions and analyze the risk management for a pool of stylized GMAB contracts. I investigate whether the choice of a suitable hedging strategy can help to reduce the risk for the insurance company. Comparing several cross-hedging strategies, I observe very similar hedging performances. Particularly, I find that well-established but complex strategies from mathematical finance do not outperform simple and naive approaches in the context studied. Diversification, however, could help to reduce the adverse impact of basis risk.