Hedging : scaling and the investor horizon

This paper examines the volatility and covariance dynamics of cash and futures
contracts that underlie the Optimal Hedge Ratio (OHR) across different hedging time
horizons. We examine whether hedge ratios calculated over a short term hedging
horizon can be scaled and successfully applied to longer term horizons. We also test
the equivalence of scaled hedge ratios with those calculated directly from lower
frequency data and compare them in terms of hedging effectiveness. Our findings show
that the volatility and covariance dynamics may differ considerably depending on the
hedging horizon and this gives rise to significant differences between short term and
longer term hedges. Despite this, scaling provides good hedging outcomes in terms of
risk reduction which are comparable to those based on direct estimation.