Optimal hedging under departures from the cost-of-carry valuation: evidence from the Spanish stock index futures market

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Instituto Complutense de Análisis Económico. Universidad Complutense de Madrid
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We provide an analytical discussion of the optimal hedge ratio under discrepancies between the futures market price and its theoretical valuation according to the cost-of-carry model. Assuming a geometric Brownian motion for spot prices, we model mispricing as a speci…c noise component in the dynamics of futures market prices. Empirical evidence on the model is provided for the Spanish stock index futures. Ex-ante simulations with actual data reveal that hedge ratios that take into account the estimated, time-varying, correlation between the common and speci…c disturbances, lead to using a lower number of futures contracts than under a systematic unit ratio, without generally losing hedging e¤ectiveness, while reducing transaction costs and capital requirements. Besides, the reduction in the number of contracts can be substantial over some periods. Finally, a meanvariance expected utility function suggests that the economic bene…ts from an optimal hedge are substantial.
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