Analysis of optimal hedge ratio and hedging effectiveness in Taiwan stock exchange capitalization weighted stock index (TAIEX) futures

Abstract

Theoretically, hedging is effective if there is a balance between the price of asset and price of hedging. The objective of this research was to determine the optimal hedge ratio and hedging effectiveness using Vector Autoregression (VAR) and Vector Error Correction Model (VECM) on TAIEX (Taiwan Stock Exchange Capitalization Weighted Stock Index) Futures. This research provides the conclusion about the more reliable model that can best explain the hedging effectiveness. The daily data were classified into two periods, those are In-Sample Period (January 1st, 2012-December 31st, 2015) and Out-Sample Period (January 1st-December 31st, 2016) and were collected on spot and futures index market of TAIEX. The results of this study stated that VECM model provides greater variance reduction compared to the VAR model on both in-sample period and out-of-sample period. The conclusion was a VECM model is more reliable to determine hedging effectiveness for managing the risk.