Dynamic hedging strategy in incomplete market: Evidence from Shanghai fuel oil futures market

a r t i c l e i n f o Keywords: Multivariate GARCH model Optimal hedge ratio Market noise conditional volatility This paper introduces a new incomplete index and establishes a new optimal hedging model. We find that when the market micro-noise is perfectly negatively correlated with the return of futures market, market incomplete-ness depends on the relative level of noise volatility. Especially when noise volatility is less than the futures market yield, noise volatility will be offset by return volatility. As a result, complete optimal hedging model emerges. As an aside, it is interesting to note that as different conditional variances derived from different volatility models being applied, the hedge performance tends to be basically consistent with subtle difference: DCC–GARCH model is more likely to execute the hedging with 1:1 ratio, while other multivariate GARCH models would give a hedging ratio with greater probability less than 1:1 and is less likely to be a perfect hedge. Therefore, we believe that a simpler econometric model might produce better empirical results. The launch of stock index futures traded on Chinese Financial Futures Exchange On April 16th, 2010, opened a new era for China's financial industry, offering a new derivative product for hedging, given current insufficient investment and financing channel in Chinese capital market. The chairman of CSRC, Guo Shu-qing has remarked that crude oil futures is likely going to be launched within 2012, and expected to be the third global crude oil trading center after the USA and the UK, in order to gain pricing power. China's futures market has developed for more than twenty years, with twenty seven futures products, however , there is still a huge gap between the development of derivative products and the needs of real economy; especially for fossil oil, as China consumes huge quantity of fossil oil, nevertheless without pricing power, which constrains the economic development; given recent volatile crude oil price movement, the market urgently needs new financial derivative for crude oil to mitigate investment risk. With only fuel oil futures currently available in the market, the lack of hedging tools and strong speculative sentiment is the major concern among many concerns by Chairman Guo. The launch of stock index futures makes certain hedging activities possible. However, there are many institutional constrains in China's market, for instance, information asymmetry between buyers and sellers, short-sale constrains, margin system, price-movement limits; thus the market is …