Measuring the hedging effectiveness of index futures contracts: Do dynamic models outperform static models? A regime-switching approach

Abstract

This paper estimates linear and non-linear GARCH models to find optimal hedge ratios

with futures contracts for some of the main European stock indexes. By introducing

non-linearities through a regime-switching model, we can obtain more efficient hedge

ratios and superior hedging performance in both in-sample and out-sample analysis

compared with other methodologies (constant hedge ratios and linear GARCH).

Moreover, non-linear models also reflect different patterns followed by the dynamic

relationship between the volatility of spot and futures returns during low and high

volatility periods.