Analysis of Hedging Effectiveness of Index Future Against Stock Indices Movement - Research Paper Example

Hedging is one of the most important functions of any stock index future as it helps in reducing and controlling the risk which may cause unfavorable changes in price on the spot market while at the same time increases the value of the relevant stock index (Stoll and Whaley 2015). Apart from the efficiency of the futures market, the choice of an effective hedging strategy is crucial for those who are hedging. It should be noted that for effective hedging the successful use of contracts in the future for matters hedging has become the primary concern and center of discussion on getting the finest hedge ratio and hedging helpfulness in experimental financial research (Arouri, Jouini and Nguyen 2012).

The new advancements in the time run econometrics have also contributed to juggling around with the conventional ways used so far and revamped the whole gamut of experimental research to establish the hedge ratio successfully. The traditional knowledge suggests that the optimal hedge ratio is supposed to have a 1:1 situation to successfully hedge a single unit of spot location to have a single unit of a futures contract (Stoll and Whaley 2015).This approach frequently referred to as a naïve-hedging strategy botched to deliver as the progress between the place and prices in the future are not harmonized.

This has, therefore, resulted in a transformed interest at the level of theoretical by works. They used a portfolio method to determine the most favorable hedging through the use of expected utility maximization that cuts down to the lowest variance analysis as the best case. Hedging is one of the common characteristics of the derivative markets Johnson; hedging is one of the common and effective ways of managing systematic risk in the derivative markets. The main concept of hedging is to help in fixing the price level of the future transaction of the financial instruments to an acceptable level (Arouri et al., 2012). Some of the financial instruments include the future, forwards, and options.