Abstract
This study introduces basic concepts about hedging and provides an overview of common hedging practices. This theoretical introduction is followed by an empirical application in which the hedging effectiveness of the VIX ETPs is evaluated. The iPath Series B S&P 500 VIX Short Term Futures ETN (VXX) and the SPDR S&P 500 Trust ETF (SPY) are taken for the empirical application. Dynamic conditional correlations between the VXX and SPY are obtained from DCC-GARCH framework. Based on the estimated conditional volatilities of the SPY and the hedged portfolio, a hedging effectiveness index is constructed. Results show that the hedging effectiveness of the VXX increases in turbulent periods such as the last three months of 2018 marked by the plummeting oil prices, increasing uncertainties about the Brexit deal, and rising federal funds rates and the month of March 2020 when the COVID-19 pandemic became a global concern.
TopIntroduction
Investors need to secure their holdings against adverse price movements in financial markets. Hedging is a common practice followed by informed investors to reduce their exposure to risk. Options and futures are widely used to hedge against the variability in their underlying asset returns. Futures have very high positive correlation with underlying assets. In this case, hedging strategy consists of taking opposite positions, i.e., going long in futures and short in the underlying or vice versa. This strategy may provide a nearly perfect hedge, but that does not come without a cost: the hedged portfolio would generate considerably lower returns. It may be desirable for investors to set a lower target hedging level to earn higher portfolio returns. Alternatively, commodities like gold and silver are also used for hedging and diversifying equity portfolios provided that these commodities are weakly correlated with equities.
Since the Long Term Capital Management hedge fund collapse in 1998, financial instabilities have become a growing concern for investors as the financial markets have frequently gone through several crises. The global financial crisis in 2008 (GFC) and the recent global pandemic of Covid-19 have been the most devastating ones, and compared to the GFC the latter had more severe impacts on the financial markets (Sharif et al., 2020). In March 2020, large and sudden drops in the U.S. stock and futures markets triggered circuit breaker mechanism four times in ten days, while trading was never halted during the GFC (Zhang et al., 2020). Although during both crises the volatility spiked to similar extremely high levels, the crisis evolved much faster in 2020 (Löwen et al., 2021). This fact is also reflected by significantly higher volatility of volatility levels observed during the Covid-19 pandemic (Brenner and Izhakian, 2021). In such turbulent periods, investors need to reconsider the effectiveness of hedging instruments. It is now well known that correlations between different asset classes tend to increase during financial crises. During the GFC, significant increases in correlations between stocks, bonds and commodities cast doubt on standard risk management practices (Szado, 2009). In high volatility periods, spot-futures relationship may also be weakened leading to a deterioration in hedging effectiveness of futures (Ait-Sahalia and Xiu, 2016).
Key Terms in this Chapter
Financial Derivative: A financial contract with a value that varies conditionally on the changes in the underlying reference prices.
Cross Hedging: A hedging strategy that is adopted when a derivative for the asset to be hedged does not exist. It involves using an asset that is highly correlated with the asset to be hedged, to cover potential losses from one asset with gains from the other one.
Exchange Traded Note: An unsecured debt obligation that is issued by large banks and financial institutions. It tracks the performance of an index or a benchmark and pays its holders the amount of returns equal to those that are generated by what it tracks.
Price Risk: The potential for the decline in the value of an asset, a portfolio, or a financial instrument.
Volatility Risk: The potential for a sharp decline in the value of an asset, a portfolio or a financial instrument as a result of changes in volatility of returns on the investment itself, or on a related entity such as the market or the underlying.
Exchange Traded Fund: A marketable security that tracks the value of another security, an index, or an industry.
Optimal Hedge Ratio: The ratio of the value of a hedging instrument to that of the asset to be hedged, needed to minimize the variance of the overall position.