An Investigation into the Hedging Effectiveness of the Irish Interest Rate Futures Market

Introduction The economic rationale for the existence of futures markets is that they facilitate hedging: they allow the more risk averse market participants to transfer the risk of price changes to speculators more willing to bear such risks. Recent fluctuations in interest rates and currencies bear testament to the need for such a hedging mechanism. Accordingly, the effectiveness with which such markets facilitate hedging is of considerable interest. This paper is concerned with the hedging effectiveness of the three interest rate futures contracts traded on the Irish Futures and Options Exchange (IFOX). This exchange commenced operations on 29th May, 1989. Both the 3 month DIBOR Contract and the 20 year Long Gilt Contract have been traded from this date. Due to the volatility of long-term interest rates in recent years, the Long Gilt Future is frequently traded for both speculative and hedging purposes. The DIBOR futures contract has a broader based use, which is reflected in its high trading volume. On September 6th 1990, IFOX launched a future on a notional 5-year Government Gilt and there has been substantial activity in this contract. Hogan (1990) undertook a preliminary analysis of the hedging effectiveness of IFOX futures contracts. His study is restricted to the September 1989 Long gilt future which traded from 29 May 1989 to 20 September 1989. In this paper we examine the hedging effectiveness of the DIBOR, Long Gilt and Short Gilt futures over a significantly longer time period. Consequently, we can compare the hedging effectiveness of the various IFOX-traded futures. Our much larger sample allows us to examine hedges of different lengths and to observe some of the factors upon which hedging effectiveness is hypothesised to depend. In addition, we undertake a comparative analysis for the corresponding futures traded on the London International Financial Futures Exchange (LIFFE). In the next section we outline briefly the theory which underlies our methodology. In the third section of the paper we describe the empirical analysis and results pertaining to hedging effectiveness. Section 4 deals with the impact of hedging on portfolio returns. We conclude with a summary of our findings. Hedging Hedging can be defined as taking a position in one asset so as to reduce or eliminate exposure to adverse price movements in another asset. Futures markets facilitate hedging for investors who are long (short) in the spot market by allowing them to sell (buy) related futures contracts. A perfect hedge occurs where the losses on the spot position are exactly offset by gains in the futures market. Such perfect hedges are only possible when one can predict the change in basis (the difference between the futures price and the spot price) with certainty. In practice such perfect hedges are rarely possible because the relationship between futures and spot prices is not deterministic, except to the extent that they will converge at the settlement date of the futures contract if the asset being hedged corresponds exactly to that underlying the futures contract. Futures prices may not track spot prices perfectly because they represent investments at different points in time or deliverable at different locations, or because the investment being hedged may differ significantly from that specified in the futures contract (a crosshedge). Thus, the basis might change in a manner that is not perfectly predictable if (a) the period of the hedge is such that the futures position is closed out and the hedge lifted before the settlement date of the futures contract or (b) the asset underlying the futures contract does not correspond exactly to that which is being hedged. This implies that the hedger is usually exposed to some risk. The residual risk that exists after hedging is termed basis risk. The hedging effectiveness of a futures market is defined in tens of the potential for risk reduction. …