Hedging performance of volatility index futures: a partial cointegration approach

Abstract

Using the Clegg–Krauss framework, this paper first examines a partial cointegration relationship between stock index futures and VIX futures prices and then constructs a hedging strategy based upon this relationship. This paper argues that the stock index futures and the VIX futures are both affected by unobservable investor sentiment and thus the price series should be modelled by the partial cointegration relationship. Our empirical results validate a partial cointegration relationship between stock index and VIX futures prices. Based upon the partial cointegration relationship between stock index futures and VIX futures prices, we demonstrate that the proposed strategy outperforms conventional strategies, e.g., OLS, VAR, and VECM, in terms of tail risk reduction and expected utility, especially when the length of the hedge horizon increases. In addition, the partial cointegration-based strategy becomes more dominant when the stock index futures price is near its historical high. Overall, our empirical evidence of the hedging effectiveness for different hedge horizons and market timing with VIX futures provides valuable information for practitioners in risk management.