Constant vs. time-varying hedge ratios and hedging efficiency in the BIFFEX market

This paper estimates time-varying and constant hedge ratios, and investigat es their performance in reducing freight rate risk in routes 1 and 1A of th e Baltic Freight Index. Time-varying hedge ratios are generated by a bivari ate error correction model with a GARCH error structure. We also introduce an augmented GARCH (GARCH-X) model where the error correction term enters i n the specification of the conditional covariance matrix. This specificatio n links the concept of disequilibrium (as proxied by the magnitude of the e rror correction term) with that of uncertainty (as reflected in the time va rying second moments of spot and futures prices). In- and out-of-sample tes ts reveal that the GARCH-X specification provides greater risk reduction th an a simple GARCH and a constant hedge ratio. However, it fails to eliminat e the riskiness of the spot position to the extent evidenced in other marke ts in the literature. This is thought to be the result of the heterogeneous composition of the underlying index. It seems that restructuring the compo sition of the Baltic Freight Index (BFI) so as to reflect homogeneous shipp ing routes may increase the hedging effectiveness of the futures contract. This by itself indicates that the imminent introduction of the Baltic Panam ax Index (BPI) as the underlying asset of the Baltic International Financia l Futures Exchange (BIFFEX) contract is likely to have a beneficial impact on the market. (C) 2000 Elsevier Science Ltd. All rights reserved.