A clustering time series model for the optimal hedge ratio decision making

Abstract

In this study, a novel procedure combining computational intelligence and statistical methodologies is proposed to improve the accuracy of minimum-variance optimal hedge ratio (OHR) estimation over various hedging horizons. The time series of financial asset returns are clustered hierarchically using a growing hierarchical self-organizing map (GHSOM) based on the dynamic behaviors of market fluctuation extracted by measurement of variances, covariance, price spread, and their first and second differences. Instead of using original observations, observations with similar patterns in the same cluster and weighted by a resample process are collected to estimate the OHR. Four stock market indexes and related futures contracts, including Taiwan Weighted Index (TWI), Standard & Poor\'s 500 Index (S&P 500), Financial Times Stock Exchange 100 Index (FUSE 100), and NIKKEI 255 Index, are adopted in empirical experiments to investigate the correlation between hedging horizon and performance. Results of the experiments demonstrate that the proposed approach can significantly improve OHR decisions for mid-term and long-term hedging compared with traditional ordinary least squares and naive models. (C) 2014 Elsevier B.V. All rights reserved.