Hedging in the interest rate markets.

Abstract

The suitability of GARCH and EGARCH models in a cross-hedging framework is also examined whereby a T-bill spot position is hedged with Eurodollar futures. The naive and risk-minimization models are also included in this extension. The T-bill spot asset is chosen for this study because managers of T-bill portfolios commonly cross-hedge with Eurodollar futures. Evidence of cointegration between the two markets is factored in with an error correction representation. Consistent with previous results, the time-varying hedge ratio models outperform the constant hedge ratio models. Unlike the Eurodollar option/futures results where EGARCH is superior to GARCH, the within-sample and out-of-sample tests in the T-bill/Eurodollar cross-hedge show that GARCH and EGARCH hedging performance is virtually identical.

This study explores how market makers in the Eurodollar options on futures hedge their option positions using Eurodollar futures. The delta neutrality hedging model based on Black's option pricing model (OPM) is examined as well as several hedging methodologies extensively studied for spot/futures portfolios. These include naive, risk-minimization, and bivariate GARCH models. A bivariate EGARCH hedge is developed as an alternative hedging model. Results suggest that the OPM delta hedge is the most effective on both a within-sample and out-of-sample basis. Consistent with previous studies, the time-varying hedge ratio models outperform the risk-minimization and naive models with constant hedge ratios. In the option/futures framework, the superior performance of the bivariate EGARCH hedge looks promising for extensions to spot/futures portfolios and other derivatives.