The Minimum Variance Hedge Ratio Under Stochastic Interest Rates

Abraham Lioui () and Patrice Poncet ()
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Patrice Poncet: University of Paris I---Sorbonne, 17 rue de la Sorbonne, 75005 Paris, France, and ESSEC, Département Finance, Avenue Bernard Hirsch B.P.105, 95021 Cergy-Pontoise Cedex, France

Management Science, 2000, vol. 46, issue 5, 658-668

Abstract: In an environment where interest rates are stochastic, we examine the case of a "pure" hedger endowed with a fixed position in a long term bond. In contrast to conventional wisdom according to which the difference between hedging through forward contracts and futures is immaterial, it turns out that the minimum variance hedge ratio using forwards comprises two terms instead of one only when using futures. The magnitude of the difference between the two hedge ratios may be important under some plausible assumptions. This result is due to the presence of additional interest rate risk that bears on the profit-and-loss statement associated with the forward position. This sheds some additional light on the respective features of forward and futures contracts written on interest rate-sensitive securities.

Keywords: hedge ratio; stochastic interest rates; forwards; futures (search for similar items in EconPapers)
Date: 2000
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Citations: View citations in EconPapers (7)

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