Structurally sound dynamic index futures hedging

Abstract

Portfolio managers use index futures for a variety of reasons. Regardless of their motivation, they will keep a close eye on the relation between the index futures returns and their stock-portfolio returns. Whenever this relation is perceived to have changed, the manager will decide whether it is worthwhile to rebalance the index futures-portfolio mix accordingly. Exact measures as to when and how much rebalancing should occur have not yet been established. This article proposes a dynamic hedging algorithm based on a reverse order CUSUM-squared (ROC) testing procedure, first discussed in M. H. Pesaran and A. Timmermann (2002). A comparison with standard alternatives (naïve, expanding, EWLS, ..