Finance Letters, 2003, 1, 15-20

The Sensitivity of the Optimal Hedge Ratio to Model Specification

Imad A. Moosa*
La Trobe University, Australia

Abstract

This paper investigates the effect of the choice of the model used to estimate the hedge ratio on the effectiveness
of futures and cross-currency hedging using data from the stock and foreign exchange markets. Four different
models are used for this purpose to estimate the hedge ratio. The results show that model specification has little
effect on the hedging effectiveness. It seems that what matters most is the correlation between the prices of the
unhedged position and the hedging instrument.

Key words: Hedging Effectiveness, Hedge Ratio, Cross-Currency Hedging

JEL classification: G15

1. INTRODUCTION
Two important questions are involved in financial hedging: (i) to hedge or not to hedge; and (ii) if the
decision to hedge is taken, do we hedge the full position? This paper deals with the second question, which
amounts to estimating the hedge ratio or determining the size of the position on the hedging instrument that is
used to hedge a spot (cash) position. In this exercise we use data on stock prices as well as exchange rates, and
hence we deal with the hedging of exposure to equity risk and foreign exchange risk.
It has been suggested that the optimal hedge ratio can differ significantly, depending on the model that is
used to estimate the hedge ratio (Ghosh, 1993). The conventional model takes the form of an OLS regression
equation in which the dependent variable is the price of (or the rate of return on) the unhedged position, whereas
the explanatory variable is the price of (or the rate of return on) the hedging instrument (which could be a
forward or a futures contract). This model has been criticised on the grounds that it ignores short-run dynamics
(when it is specified in levels) and the long-run information embodied in the error correction term (when it is
specified in first differences). Ghosh (1993) finds the hedge ratios obtained from traditional models to be
underestimated because “these models are misspecified”. Lien (1996) shows analytically that the hedger makes
a mistake if the hedging decision is based on the hedge ratio derived from a first-difference model that does not
contain an error correction term. There is also the issue of whether or not the hedge ratio should be estimated
from a first difference or a level model, which are implicitly taken to be equivalent (see, for example, Ghosh,
1993; Witt et al., 1987). And there is the problem of whether the hedge ratio should be estimated from the
conditional or the unconditional moments, which has been dealt with by Kroner and Sultan (1993) as well as
Brooks and Chong (2001). In this paper we do not deal with this issue, but rather concentrate on whether or not
it makes any difference for hedging effectiveness if the hedge ratio is derived from (i) a levels as opposed to a
first-difference model; and (ii) a first-difference as opposed to an error correction (EC) model.

2. MEASURING THE OPTIMAL HEDGE RATIO

Let pU and pA be the logarithms of the prices of the unhedged (spot or cash) position and the hedging
instrument respectively, such that the rates of return on these positions are pU and pA respectively. The level
and first difference models are written as

*
Email: i.moosa@latrobe.edu.au

ISSN 1740-6242 © 2003 Global EcoFinance™ All rights reserved. 15

Moosa 16

pU ,t = α 1 + h1 p A,t + ε 1, t (1)

∆pU ,t = α 2 + h2 ∆p A,t + ε 2,t (2)

where h1 and h2 are the estimated hedge ratios, such that the R2 of the regressions measures the hedging
effectiveness. This procedure for calculating the hedge ratio is based on an application of the principles of
portfolio theory, as demonstrated by Johnson (1960), Stein (1961), Ederington (1979), McEnally and Rice
(1979), Franckle (1980), and Hill and Schneeweis (1982). Some economists make it sound as if the two models
represented by equations (1) and (2) are two alternative means for measuring the same thing. For example,
Giaccotto et al. (2001, p. 148) talk about minimising “the volatility of the total cash flow or, equivalently, the
change in flow”. Hill and Schneeweis (1981) recommend the use of the first-difference model only because the
model in levels produces serially correlated residuals. Strictly, speaking, however, the choice would or should
depend on whether the objective is to minimise the variance of the price or the rate of return. This is because the
variances of the hedged positions corresponding to equations (1) and (2) are

σ 2 ( p H ) = σ 2 ( pU ) + h12σ 2 ( p A ) − 2h1σ ( pU , p A ) (3)

σ 2 (∆p H ) = σ 2 (∆pU ) + h22σ 2 (∆p A ) − 2h2σ (∆pU , ∆p A ) (4)

The minimum-risk (or the minimum-variance) hedge ratios can be obtained by differentiating equations (3)
and (4) with respect to the hedge ratios and solving the first order conditions, which are written as

dσ 2 ( p H )
= 2h1σ 2 ( p A ) − 2σ ( pU , p A ) = 0 (5)
dh1

dσ 2 (∆p H )
= 2h2σ 2 (∆p A ) − 2σ (∆pU , ∆p A ) = 0 (6)
dh2
Solving the first order conditions gives
σ ( pU , p A )
h1 = (7)
σ 2 ( pA)
σ (∆pU , ∆p A )
h2 = (8)
σ 2 (∆p A )
Obviously, the hedge ratios h1 and h2 are not necessarily equal. We will find out what happens when the
hedge ratio estimated from a model in levels is used to reduce the variance of the rate of return on the hedged
position and vice versa.
One problem with equations (1) and (2) is that that equation (1) ignores short-run dynamics, whereas
equation (2) ignores the long-run relationship as represented by equation (1). Specifically, if pU and pA are
cointegrated such that ε1,t ~I(0), then equation (2) would be misspecified, in which case the correctly specified
model is an error correction model of the form
n n
∆pU ,t = α + β i ∆pU ,t −i + h∆p A,t + γ i ∆p A,t −i + θ ( pU ,t −1 − p A,t −1 ) + ξ t (9)

i =1 i =1

Lien (1996) argues that the estimation of the hedge ratio and the hedging effectiveness may change sharply
when the possibility of cointegration between prices is ignored. In Lien and Luo (1994) it is shown that although
GARCH may characterise the price behaviour, the cointegration relationship is the only truly indispensable
component when comparing the ex post performance of various hedging strategies. Ghosh (1993) concluded
that a smaller than optimal futures position is undertaken when the cointegration relationship is unduly ignored.
He attributed the under-hedge results to model misspefcification.
Lien (1996) provides a theoretical analysis of this conjecture by assuming a cointegrating relationship of the
form φt = pA,t – pU,t. A simplified error correction model, which implies that prices adjust in response to
disequilibrium, can be written as
Moosa 17

∆pU ,t = αφ t −1 + ξ1,t (10)

∆p A,t = − βφ t −1 + ξ 2,t (11)

If the hedge ratio is chosen to minimise σ2 ( pU,t – h pA,t), , then the hedge ratio is calculated as
 

σ (∆pU ,t , ∆p A,t | φ t −1 ) σ (ξ1,t )

 

 

h= =ρ  

(12)
σ (∆p A,t | φ t −1 )
2
σ (ξ 2,t )
 

where ρ is the correlation coefficient between ξ1,t and ξ2,t. Alternatively, the hedge ratio can be calculated from
the regression equation

∆pU ,t = α + h∆p A,t + γφ t −1 + ζ t (13)

If the cointegrating relationship is ignored then the hedge ratio is calculated as in (8).
From equations (10) and (11), we have

σ (∆pU ,t , ∆p A,t ) = σ (− βφt −1 + ξ 2,t ,αφ t −1 + ξ1,t )

= −αβσ 2 (φ t −1 ) + ρσ (ξ 1,t )σ (ξ 2,t ) (14)

and

σ 2 (∆p A,t ) = σ 2 (− βφ t −1 + ξ 2,t ) = β 2σ 2 (φ t −1 ) + σ 2 (ξ 2,t ) (15)

Hence, the hedge ratio is measured as

− αβσ 2 (φ t −1 ) + ρσ (ξ1,t )σ (ξ 2,t )

h= (16)
β 2σ 2 (φ t −1 ) + σ 2 (ξ 2,t )
Obviously there is a difference between the expressions in equation (16) and equation (12). On the basis of
these two expressions, Lien (1996) concludes that an errant hedger who mistakenly omits the cointegrating
relationship (by using equation 16) always undertakes a smaller than optimal position on the hedging
instrument (compared with a hedger using equation 12). This proposition is confirmed empirically by Ghosh
(1993).
By using a general specification of equations (10) and (11), we have
n n
∆pU ,t = αφ t −1 + ai ∆pU ,t −i + bi ∆p A,t −i +ξ 1,t (17)
i =1 i =0

n n
∆p A,t = − βφ t −1 +
c i ∆pU ,t −i +
d i ∆p A,t −i +ξ 2,t (18)
i =0 i =1

in which case the hedge ratio calculated on the basis of the correctly specified model is given by

σ (∆pU ,t , ∆p A,t | φ t −1 , ∆pU ,t −i , ∆p A,t −i )

h=
σ 2 (∆p A,t | φ t −1 , ∆pU ,t −i , ∆p A,t −i )

σ (ξ1,t , ξ 2,t ) σ (ξ1,t )



= =ρ  

(19)
σ (ξ 2,t )
2
σ (ξ 2,t )
 

whereas the errant hedger who does not take into account the cointegration relationship will choose a hedge
ratio that is given by

σ (∆pU ,t , ∆p A,t | ∆pU ,t −i , ∆p A,t −i )

h=
σ 2 (∆p A,t | ∆pU ,t −i , ∆p A,t −i )
Moosa 18

ρσ (ξ1,t )σ (ξ 2,t ) − αβσ 2 (φ t −1 | ∆pU ,t −i , ∆p A,t −i )

= (20)
σ 2 (ξ 2,t ) + β 2σ 2 (φ t −1 | ∆pU ,t −i , ∆p A,t −i )
which means that the errant hedger will undertake a smaller than optimal position on the hedging instrument,
incurring losses in hedging effectiveness.
For the purpose of assessing the hedging effectiveness based on various models, a hedge is considered to be
effective when the variance of the price or the rate of return of the unhedged position is significantly higher than
that of the hedged position. This will be obtained if the variance ratio satisfies the condition

σ 2 ( pU )
VR = > F (n − 1, n − 1) (21)
σ 2 ( pH )
where n is the sample size. The effectiveness of two hedges can be compared on the basis of variance reduction,
which is calculated as
1
VD = 1 − (22)
VR

Four models are used for the purpose of calculating the hedge ratio: (i) the levels model (equation 1); (ii)
the first-difference model (equation 2); (iii) a simple error correction model (equation 9 with βi = 0 and γi = 0);
and (iv) a general error correction model (equation 9).

3. DATA AND EMPIRICAL RESULTS

Two sets of data are used in this empirical exercise. The first is a set of monthly observations on cash and
futures prices of Australian stocks. The cash price is represented by the All Ords index, whereas the futures
price is represented by the SPI index. The sample, which was obtained from the Australian Stock Exchange,
covers the period 1987:1-1997:12. The second sample consists of quarterly observations covering the period
1980:1-2000:4 on the spot exchange rates of the pound and the Canadian dollar against the U.S. dollar. In this
case of cross-currency hedging the base currency is the pound, the exposure currency is the U.S. dollar, and the
currency used for hedging is the Canadian dollar. Thus, pU = S(USD/GBP) and pA = S(USD/CAD). The data
sample was obtained from the OECD’s Main Economic Indicators.
Table 1 and Table 2 report the estimated hedge ratios, the variances, variance ratios and variance reductions
for stock prices. Although the estimated hedge ratios are numerically different, the results in terms of variance
reduction are not that different. In all cases, hedging is effective and the reduction in the variance is close (over
97 per cent in all cases).

Table 1. Estimated Hedge Ratios: Stock Prices

Model Hedge Ratio R2
Level 0.995 0.99
First Difference 0.919 0.98
Simple EC 0.932 0.99
General EC 0.929 0.99

We now examine the results obtained by using exchange rates, which are reported in Tables 3 and 4. Again,
the estimated hedge ratios are numerically different but this makes little difference to the results: in no case is
the hedge effective, as the variance ratios are statistically insignificant. The reason for the difference between
these results and those obtained by using stock price data is attributed to the lack of correlation between pU and
pA in this case, unlike the previous case. What matters for the results seems to be not the model used to estimate
the hedge ratio, but rather the correlation. Results obtained by Moosa (2002) show that for an effective hedge,
the correlation coefficient between pU and pA must be at least 0.50 to produce variance reduction of about 25
 

per cent.
Moosa 19

Table 2. Hedging Effectiveness: Stock Prices

Variance Model Estimated Value VR VD
σ ( pU )
2 0.040390

σ 2 (∆pU ) 0.004251

σ 2 (∆pU − h∆p A ) Level 0.000120 35.43 97.18

σ 2 (∆pU − h∆p A ) First Difference 0.000091 46.71 97.86

σ 2 (∆pU − h∆p A ) Simple EC 0.000093 45.71 97.81

σ 2 (∆pU − h∆p A ) General EC 0.000092 46.21 97.84

*
σ 2 ( pU − hp A ) Level 0.000080 504.99 99.80
*
σ 2 ( pU − hp A ) First Difference 0.000320 126.25 99.21

*
Relative to σ2( pU).

Table 3: Estimated Hedge Ratios: Exchange Rates

Model Hedge Ratio R2
Level 0.493 0.16
First Difference 0.495 0.04
Simple EC 0.582 0.13
General EC 0.232 0.27

Table 4: Hedging Effectiveness: Exchange Rates

Variance Model Estimated Value VR VD
σ ( pU )
2 0.016500

σ 2 (∆pU ) 0.003088

σ 2 (∆pU − h∆p A ) Level 0.002957 1.04 4.24

σ 2 (∆pU − h∆p A ) First Difference 0.002957 1.04 4.24

σ 2 (∆pU − h∆p A ) Simple EC 0.002957 1.04 4.24

σ 2 (∆pU − h∆p A ) General EC 0.002999 1.03 2.88

σ 2 ( pU − hp A ) Level 0.013700 1.20* 16.97

σ 2 ( pU − hp A ) First Difference 0.013700 1.20* 16.97

*
Relative to σ2( pU).

4. CONCLUSION
It has been argued that the choice of the model used to estimate the hedge ratio makes some difference for
the effectiveness of hedging measured as the reduction in the variance of the unhedged position. This study
investigated this issue empirically by employing four different models to estimate the hedge ratios used to cover
exposure to spot positions in stocks and currencies. Although the theoretical arguments for why model
specification does matter are elegant, the difference model specification makes for hedging performance seems
to be negligible. What matters for the success or failure of a hedge is the correlation between the prices of the
unhedged position and the hedging instrument. Low correlation invariably produces insignificant results and
ineffective hedge, whereas high correlation produces effective hedge irrespective of how the hedge ratio is
measured.
Moosa 20

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