applied financial economics the hedging effectiveness of stock index fixtures (holmes & 2001)

The hedging eVectiveness of stock index
® xtures: evidence fo r th e FTSE-100 and
FTSE-mid250 indexes traded in the UK
DA RRE N BUT T ER W O R T H and P H I L H O L ME S *
{
Financial Services Team, L ondon Economics Ltd, 66 Chiltern St, London W1M 1PR,
UK and
{
Department of Economics and Finance, University of Durham, 23/26 Old
Elvet, Durham, DH1 3HY , UK
E-mail: darren.butterworth @londonecon.co.u k and
This study provides the ® rst investigation of the hedging eŒectiveness of the FTSE-
Mid250 stock index futures contract. In contrast to previous studies, the portfolios
to be hedged are actual diversi® ed portfolios in the form of investment trust com-
panies (ITCs). Furthermore, in addition to using the well established hedging
strategies, consideration is also given to hedge ratios estimated on the basis of the
Least Trimmed Squares approach. Despite relatively thin trading, the FTSE-Mid250
contract is show n to be an important additional hedging instrument. Surprisingly,
the new contract is more eŒective for hedging ITCs than is the established FTSE-10 0
contract. The study also demonstrates that previous studies overstate the hedging
eŒectiveness of UK stock index futures, in that they assume the portfolio to be
hedged is one which underlies a broad market index.
I. I N T ROD UCT I O N
Futures contracts play an important practical role by
expanding the investor opportunity set through the intro-
duction of negative correlation not typically found in cash
markets. The existence of stock index futures contracts
allows investors to avoid market risk, not easily avoided
using cash assets alone, due to short selling restrictions.
Stock index futures were introduced in the UK in May
1984 when trading began in the FTSE-100 contract on

the London Inte rnational Financial Futures Exchange
(LIFFE). This provided investors with the mean s to
hedge the risk associated with a broadly diversi® ed stock
portfolio. However, since the contract relates to an index
comprising the 100 highest market capitalization ® rms, it is
questionable whet her it is suitable for hedging risk associ-
ated with portfolios of smaller companies stocks. To
expand the opportunity set further and allow the hedging
of the risk of such stocks, futures trading on the FTSE-
Mid250 (hereafter, Mid250) index began in February 1994.
To date trading has been thin compared to that in the
FTSE-100 contract. For example, open interest in the
Mid250 contract is frequently only about 5% of that in
the FTSE-100, while the value of each Mid250 contract
typically has been less than 50% of that of the FTSE-100.
Trading volume in the new contract suggests that while it
oŒers new risk reduction opportunities in principle, its prac-
tical signi® cance is limited in that it provides little extra
hedging opportunity compared to the FTSE-100 contract.
This study investigates whether the new contract is eŒec-
tive for hedging a range of stock portfolios and compares
its hedging performance with that of th e FTSE-100 con-
tract. In addition to providing the ® rst test of hedging
eŒectiveness of the new contract, the study oŒers improve-
ments on previous studies of stock index futures hedging.
In particular, a wide range of cash portfolios is used for
assessing hedging performance, by using not only portfo-
lios which mirror indexes underlying futures contracts, but
Applied Financial Economics ISSN 0960± 3107 print/ISSN 1466± 4305 online
#

2001 Taylor & Francis Ltd
/>Applied Financial Economics, 2001, 11, 57± 68
57
*Corresponding author.
also a spread of investment trust companies (ITCs).
1
Examining hedging eŒectiveness over such a range of
cash portfolios makes it possible to determine whether
the new contract adds substantially to investors’ oppor-
tunity sets by markedly enhancing hedging performance.
Previous studies of stock index futures hedging have ex-
amined performance for cash portfolios which underlie
broad market indexes or portfolios constructed speci® cally
for the analysis. By utilizing ITCs, the contracts’ perform-
ance is assessed for hedging actual diversi® ed portfolios,
rather than portfolios constructed by the researcher.
Further-more, in addition to using the well established he d-
ging strategies, consideration is also given to hedge ratios
estimated on the basis of the Least Trimmed Squares
approach. Further features are tha t the ® rst analysis of
daily hedging using UK futures is provided and, unlike
previous studies, consideration is given to using a combi-
nation of contracts (the Mid250 and the FTSE-100) to
hedge.
The rest of the paper is organized as follows. The next
section brie¯ y reviews previous empirical studies to identify
research issues requiring further investigation. A section
setting out the data and method used follows and the
results ar e then presented. A ® nal sectio n provides a sum-
mary and conclusions.

II . P R E VIO U S EM P I R I C A L S T UD IES AND
RE S E A RCH I S SUES
The ® rst analysis of hedging eŒectiveness of stock index
futures was by Figlewski (1984) and considerable work
followed. Researchers have concentrated on three hedge
strategies: the traditional one-to-one hedge; the beta
hedge; and the minimum variance hedge, proposed by
Johnson (1960).
2
With all three strategies there is a need
to determine the hedge ratio, h, which measures the ratio of
the number of units traded in the futures market to the
number of units traded in the cash market. The traditional
strategy involves hedgers adopting a futures position equal
in magnitude but opposite in sign to the cash position, i.e.
h ˆ ¡1. Implicit in such a strategy is the view that futures
and cash prices move closely together. Indeed, if propor-
tionate price changes in one market exactly match those in
the other market, then price risk is eliminated. The beta
hedge strategy is very similar, but recognizes that the cash
portfolio to be hedged may not match the portfolio under-
lying the futures contract. With the beta hedge strategy, h is
calculated as the negative of the beta of the cash portfolio.
Thus, for example, if the cash portfolio beta is 1.5, the
hedge ratio will be ¡1.5, since the cash portfolio is expected
to move by 1.5 times the movement in the futures contract.
Where the cash portfoli o is that which underlies the futures
contract, the traditional strategy and th e beta strategy yield
the same valu e for h.
In practice, price changes in the two markets do not

move exactly together and, therefore, the traditional or
beta hedge will not minimize risk. The minimum variance
hedge ratio (MVHR) takes account of this imperfect cor-
relation and identi® es the hedge ratio which minimizes risk
(as measured by variance) as h* in Equation 1:
h* ˆ ¡
Cov…R
s
;
R
f
†
Var…R
f
†
…1†
Again, the negative sign re¯ ects that to hedge a long stock
position requires selling futures. Using the MVHR as the
basis for hedging implicitly assumes investors are in® nitely
risk averse, i.e. they will forgo an in® nite amount of
expected return in exchange for an in® nit ely small risk
reduction. While such an assumption about the risk-return
trade-oΠis unrealistic, the MVHR provides an unam-
biguous benchmark against which to assess hedgin g
performance.
3
The majority of research on stock index futures hedging
relates to the USA, although more recently work has been
published in relation to the FTSE-100 contract. This sec-
tion aims to outline the main themes of previous research,

and identify shortcomings and areas where further devel-
opment is required. Figlewski (1984) examined hedging
eŒectiveness for the S&P 500 futures contract in relation
to portfolios underlying ® ve major stock indexes for the
period June 1982 to September 1983. While all ® ve indexes
represented diversi® ed portfolios, two included only the
largest capitalization stocks, two included smaller com-
panies and one contained only 30 stoc ks of very large
® rms. Figlewski included dividend payments in the return
series, but found that their inclusion did not alter the
results. Consequently, and given the relatively stable and
predictable nature of dividends, subsequent studies have
excluded dividends. Figlewski showed that ex post
MVHRs can be estimated by OLS using historical data.
He found that for all indexes hedge performance was less
good using the beta hedge ratio than when the MVHR was
used. With large capitalization portfolios, risk was reduced
58 D. Butterworth and P. Holmes
1
An ITC is a company formed for the purpose of holding inve stments. It is a closed end fund which raises capital by issuing shares and
uses that capital to buy shares in other companies. The ITC is managed full-time by a specialist. In the context of the USA, an ITC i s
similar to a mutual fund.
2
Other researchers associated with this approach include Stein (1961) and Ederington (1979).
3
While some studies have incorporated expected returns into hedging decisions and developed risk-return measures of hedging eŒec-
tiveness (see, for example, Howard and D’Antoniou (1984, 1987) and Chang and Sh anker (1987)), such models suŒer from the same
shortcoming in that they require a subjective assessment to be made in relation to inve stor preferences.
by 70% ± 80% using the MVHR. For smaller stocks port-
folios , hedgin g eŒectiveness was considerably reduced.

Hedging performance was less good for overnight hedges
than for one week and four week hedges.
Figlewski (1985) investigated hedging performance for
three stock index futures for holding periods ranging
from one day to three weeks. As with his earlier analysis,
eŒectiveness improved as the duration of the hedge
increase d from days to weeks. Once again, portfolios of
small stocks were hedged less eŒectively than were those
comprising large stocks. Junkus and Lee (1985) tested hed-
ging eŒectiveness of three USA stock index futures
exchanges using four commodity hedging models. They
found the MVHR was most eŒective at reducing the risk
of a cash portfolio comprising the index underlying the
futures contract. Peters (1986) also con® rmed the super-
iority of the MVHR over the beta hedge.
Graham and Jennings (1987) were ® rst to examine hed-
ging eŒectiveness for cash portfolios not matching an
index. Random sampling techniques were used to form
90 equity portfolios each comprising ten stocks.
Interestingly this study found that stock index futures
were less than half as eŒective at hedging non-index port-
folios as they were at hedging cash indexes. Finally for the
USA, Lindahl (1992) examined hedge duration and hedge
expiration eŒects for the MMI and S&P 500 futures con-
tracts. Lindahl’s results suggested that both hedge ratios
and hedging eŒectiveness increase as hedge duration
increases. However, there was no obvious pattern in
terms of risk reduction in relation to time to expiration.
Hedging eŒectivenes s for the UK was ® rst examined by
Holmes (1995), for the FTSE-100 contract. Ex ante

MVHRs for the period 1984-1992 were used and the cash
portfolio hedged was that underlying the futures contract.
His results showed that even using ex ante hedge ratios, the
contract enabled risk reduction of more than 80% . Holmes
(1996) investigated ex post hedging eŒectiveness for the
same contract and the same cash portfolio as in the earlier
paper and showed that standard OLS provided MVHR
estimates superior to those estimated by GARCH or
using an error correction method. His results suggested
eŒectiveness increased with hedge duration, in line with
Figlewski and Lindahl for the USA, but that there was
no strong discernible pattern in expiration eŒe cts.
The impact of portfolio composition on systematic risk
and hedging eŒectiveness was examined by Holmes and
Amey (1995). They constructed portfolios of UK stocks
and considered the FTSE-100 contract. As the number of
stocks in portfolios increased from 1, through 5, 10, 15 and
20, to 25 hedging eŒectiveness increased markedly. While
previous studies suggested th e FTSE-10 0 contract removed
approximately 80% of cash portfolio risk when the portfo-
lio was the underlying index, risk reducti on was only about
60% for portfolios comprising 25 stocks.
There are a number of points to draw from the studies
considered. First, the MVHR provides superior hedging
performance in terms of risk reduction. Second, a duration
eŒect is evident, with longer hedges more eŒective. In con-
trast, there is no strong evidence of expiration eŒects.
Third, the nature of the portfolio hedged is an important
determinant of hedging performance. For example,
Figlewski (1984) found hedging eŒectiveness was less for

portfolios comprising small stocks, Graham and Jennings
(1987) found the hedging of portfolios comprising only ten
stocks was much les s eŒective than for portfolios matching
an index and Holmes and Ame y (1995) found similar
result s for the UK . While the composition of the cas h
portfolio is clearly important, previous studies have failed
to address true hedging eŒectiveness by examining per-
formance for actual stock portfolios. Portfolios used for
examining hedging eŒectiveness have been either market
indexes or constructed by the researcher. In addition, to
date no analysis has been undertaken of the eŒectiveness of
UK stock index futures when hedging small capitalization
stocks. Furthermore, in relation to the UK, no considera-
tion has been given to performance over very short dura-
tions. It is also worth noting that as yet no attention has
been give n to the hedging eŒectiveness of the Mid250 con-
tract and to whether this contract provides market partici-
pants with another important means by which to hedge
stock portfolio risk.
Finally, consideration needs to be given to the way in
which hedge ratios are estimated. In particular, while the
OL S estimation of the MVHR has many desirable charac-
teristics it is associated with the unattractive property of
being sensitive to outliers. Therefore, in order to allow for
this problem and take account of the fact that futures
prices are often characterized by kurtosis, it may be desir-
able to generate hedge ratios using an approach which
minimizes the impact of outliers. One such approach is
the Least Trimmed Squares (LTS) method employed by
Knez and Ready (1997). The LTS approach trims a pro-

portion of the most extreme observations and then ® ts the
remaining observations using ordinary least squares. Thus
the LTS coe cient represents the value that minimiz es the
sum of the squared residuals where the sum is taken over
all the observations which are not trimmed. If the MVHR
is considerably diŒerent to the hedge ratio generated using
LTS, then this would strongly indicate that the MVHR is
being driven by a small sample of extreme observations and
raises concerns over the possible biasedness of the MVHR.
This would have important implications when ex ante
hedge ratios are determined on the basis of estimations
using historical data.
This study addresses shortcomings of previous work in a
number of important ways:
. The ® rst assessment of hedging eŒectivenes s of the
Mid250 contract is presented. In addition, compari-
Hedging eVectiveness for cross hedges 59
sons are made between the performance of this con-
tract and that of the FTSE-100 contract for a number
of diŒerent portfolios. Given that one aim of the intro-
duction of the new contract is to enable more eŒective
hedging of small capitalization stocks, this is clearly
important.
. In addition to assessing hedging performance for cash
portfolios mirroring broad indexes, cross hedging per-
formance is analysed by examining the hedging of
actual cash portfolios held by professional managers
in the form of ITCs. Since returns on ITCs represent
the returns on professionally managed, well diversi-
® ed, portfolios, evaluation of hedging eŒectiveness in

relation to these portfolios provides new insi ghts into
the capabilities for hedging actual portfolios.
. Consideration is given here not only to the hedging
eŒectiveness of the FTSE-100 and Mid250 when
used separately, but also to their use in combination.
. Not only are the well established hedging strategies
used, but consideration is also given to an alternative
method for generating hedge ratios by using th e LTS
approach. By comparing hedge ratios estimated by
OL S with those determined using LTS it should be
possible to determine the importance of outliers on
the estimated hedge ratios.
. The ® rst investigation of hedging eŒectiveness of stock
index futures in the UK over short periods is provided,
by examining daily hedges.
II I . D A T A A N D M ETH OD
Hedging performance is examined for the FTSE-100 and
Mid250 index futures contracts traded on LIFFE by using
cash and futures return data for February 1994 (date of
introduction of the Mid250 contract) to December 1996.
The FTSE-100 represents the 100 largest companies traded
on the London Stock Exchange. The Mid250 represents the
next 250 largest companies (i.e. numbers 101 to 350 by
market capitalization). Both indexes are weighted by mar-
ket capitalization.
Thirty-six cash portfolios comprising four indexes and
32 investment trusts are used. The four indexes are the
FTSE-100, the Mid250, the FTSE-350 (comprising the lar-
gest 350 companies) and the FT Investment Trust (FTIT)
index. The ITCs were chosen to provide a range of portfo-

lios which diŒer substantially in their composition. Seven
categories of ITC s are used:
4
(1) General fun ds: at least 80% of the assets are in UK
registered companies;
(2) Capital Growth funds: at least 80% of the assets are
in UK registered companies, with stocks chosen to
accentuate capital growth;
(3) Income Growth funds: at least 80% of their assets
are in UK equities whose policy is to accentuate
income growth;
(4) High Income funds: at least 80% of assets are in
equities and convertibles; the aim is to achieve a
yield in excess of 125% of that of the FT Actuaries
All-Share Index;
(5) Smaller Company (SC) funds: at least 50% of assets
are in smaller and medium sized companies;
(6) Venture and Development Capital (VDC) funds: a
signi® cant portion of the trusts’ portfolio is invested
in securities of unquoted companies; and
(7) Property funds: at least 80% of the assets of these
funds are in listed property equities.
For each of the ® rst six categories, returns on ® ve ITCs are
used to analyse hedge eŒectiveness. In the case of Property
funds, only two ITCs were used due to a lack of appro-
priate funds with su ciently long returns series. To allevi-
ate any problems arising fro m thin trading only funds with
a market capitalization in excess of £20 million at the
beginning of the period under investigation are included.
The funds provide a broad range of portfolios, which diŒer

in terms of objectives and composition. In particular, the
SC funds and th e VDC funds represent investments in rela-
tively low capitalization stock. Hedgi ng such funds is
expected to be less eŒective with the FTSE-100 contract,
given the composition of the underlying index. It is there-
fore of interest to determine if this is the case and whether
the Mid250 contract adds markedly to hedging perform-
ance for such portfolios.
Analysis is carried out for two diŒerent hedge durations:
daily and weekly. Hedge durations of longer than a week
are not considered due to problems of sample size. After
removing non-trading days the daily series consists of 715
observations, the weekly series 148 observations. The
returns series for each cash portfolio and each futures con-
tract is calculated as the logarithmic price change:
R
t
ˆ log

P
t
P
t¡1
´
…2†
where, R
t
is the daily or weekly return on eithe r the cash or
futures position and P
t

is the price at time t.
Price is the daily or weekly closin g price. All data w ere
obtained from Datastream.
Four hedging strategies are considered. First, the tradi-
tional hedge is examined. Second, the MVHR, as shown in
Equation 1, is used. Figlewski (1984) showed the MVHR
can be estimate d by regressing cash returns on futures
60 D. Butterworth and P. Holmes
4
The de® nitions of these categories of ITCs are taken from the Association of Investment Trust Companies’ monthly report.
returns using historical information, with h* the negative of
the slope coe cient, b, in the following equation:
RS
t
ˆ a ‡ bRF
t
‡ e
t
…3†
where RS
t
is the return on the cash portfolio in time period
t; RF
t
is the return on the futures contract in time period t;
e
t
is an error term and a, b are regression parameters, where
¡b is the MVHR, h*.
Third, the LTS hedge ratio is investigated. In order to

generate the L TS hedge ratio the residual series from the
estimated equation (e
t
in Equation 3) is collected. Both the
cash and futures returns are then ranked in relation to the
absolute size of their associated residua l term. The ® rst
observation in both the cash and futures return series are
associated with the smallest residual in absolute size and
the ® nal observation in both the cash and futures returns
series is associated with the largest residual in absolute size.
In view of the ® ndings of Knez and Ready (1997) and the
number of observations in our daily and weekly samples we
adopt a trimming coe cient of 10% .
5
This trims away the
10% of cash and futures returns which are associated with
the largest residuals, measured in absolute size. This pro-
duces a trimmed daily sample of 643 observations and a
trimmed weekly sample of 13 2 observations. Having
trimmed away the extreme outlier s from both samples,
the LTS hedge ratios are then estimated by employing
OL S to the remaining 90% of observations.
Finally, given that cross hedges are being considered, the
beta hedge is used. The beta hedge ratio is calculated as the
negative of

in the following equation:
6
RS
t

ˆ
¬
‡

RIND
t
‡
"
t
…4†
where RIND
t
is the return on the index underlying the
futures contract;
"
t
is an error term and all other terms
are as previously de® ned.
Consideration is given to mean and standard deviation
of returns of the unhedged and the hedged positions. In
addition, the degree of risk reduction will be determined as:
Risk reduction ˆ
¼
u
¡
¼
h
¼
u
£ 100 …5†

where
¼
u
is the standard deviation of returns on the
unhedged (i.e. cash) position;
¼
h
is the standard deviation
of returns on the hedged position.
The eŒectiveness of the four strategies is investigated
using the FTSE-100 and the Mid250 contracts individually.
In addition, for the MVHR and LTS strategies composite
hedges are examined, where the two futures contracts are
combined into a `synthetic’ FTSE-350 contract. Returns on
the synthetic futures are the weighted average of returns on
the FTSE-100 and Mid250 contracts, with the weights
attached to the two contracts varying from 2 : ¡1 to
¡1 : 2. Weights always sum to 1 and change at intervals
of 0.25. Thus, 13 composite hedges are considered for
each of the thirty-six cash portfolios.
7
IV. EM P I R I C A L RESUL T S
Stock market indexes
Empirical analysis begins by investigating whether the new
contract adds markedly to the abilit y to hedge broad based
cash portfolios. Therefore, the reduction in risk achieved
by the FTSE-100 an d Mid250 futures when the cash port-
folio is an index is examined. The four indexes described
above are considered. Results using traditional and beta
hedge strategies for daily and weekly hedge durations are

presented in Tables 1 and 2 respectively. For each table,
panel A shows the mean and standard deviation of returns
for cash portfolios;
8
panel B shows results when hedging
with the FTSE-100 contract; and panel C shows results
when using the Mid250 contract. In panels B and C the
hedge ratio, mean and standard deviation of returns and
percentage reduction in the standard deviation from the
unhedged position are shown.
In relation to daily data, T able 1, panel A shows that the
four cash portfolios diŒer considerably in terms of their
risk-return pro® les over the sample period. For example,
the FTSE-100 index gave an annual mean return of 7.7% ,
with a standard deviation of returns of 10.9% , compared
to ® gures for the Mid250 of 4.5% and 7.0% respectively. In
terms of hedging, the traditional hedge is very eŒective
when the cash portfolio is that which underlie s the contract
under consideration, as expected. For example, panel B
shows that hedging the FTSE-100 cash index with the
FTSE-100 contract achieves risk reduction of over 64% ,
while using the Mid250 contract to hedge the Mid250 index
achieves risk reduction of 45.2% (see panel C). These
Hedging eVectiveness for cross hedges 61
5
Knez and Ready generate separate regressions using ordinary least squares and then LTS for various trimming coe cients within the
range of 5% to 50% of the sample. They show that LTS slopes are similar using either 50% or 95% of the data. This implies that the
tendency for extreme observations to be in¯ uential is explained by a small percentage of the observations. We therefore choose a 10%
trimming coe cient.
6

In the remainder of the paper the hedge ratio will be referred to as a positive number for convenience, even though in practice hedging
an established spot position is likely to require selling futures.
7
By creating variou s weighted `synthetic’ FTSE 350 contracts, the panel approach provides a detailed picture of the impact on hedging
eŒectiveness arising from changes in the contribution made by the Mid 250 contract to the composition of the `synthetic’ hedge.
8
All mean and standard deviation ® gures reported in the tables and the text have been annualized to allow more convenient comparison
between hedges of diŒerent durations.
results indicate th e new contract is not as eŒective at
hedging its underlying index as is the more established
contract, using the naive strategy. The new contract is also
less eŒective at hedging the FTSE-350 index. Given the
composition of the FTSE-350 index, these results are not
surprising.
Results for other cross hedges are of more interest. First,
panel B shows that the FTSE-100 contract was not eŒective
at hedging either the Mid25 0 or the FTIT indexe s using the
traditional hedge. For both hedges the standard deviation
of returns is higher and mean returns lower for the hedged
position than for the unhedged position. In contrast, the
Mid250 contract oŒers an eŒective means by which to
cross-hedge. Table 1, panel C demonstrates that using
this contract for a traditional hedge, when the cash port-
folio is the FTSE-100, achieves risk reduction of over 36% .
Similarly, risk reduction in relation to the FTIT cash port-
folio is about one third.
Now consider the beta hedge. The traditional and beta
hedges are identical when the cash portfolio is that under-
lying the contract. For cross-hedging, the FTSE-100 con-
tract is superior when hedging the FTSE-350 (risk

reduction of 61.4% for the FTSE-100 contract, compared
to 39.7% for the Mid250 contract). However the Mid250
contract again is superior for cross-hedging other indexes.
The FTSE-100 contract achieves risk reduction of below
29% when the cash portfolio is the Mid250 or the FTIT.
In contrast, for the FTSE-100 and FTIT cash portfolios,
the Mid250 index achieves risk reduction in excess of
one third with the beta strategy. The results suggest that
for daily hedging the new contract provides an important
additional hedging vehicle for some broadly diversi® ed
portfolios.
Table 2 shows results for traditional and beta weekly
hedges. Results are very similar to those for daily data,
although the new contract’s value is more marked. When
the cash portfolio is that underlying th e contract, risk
reduction is substantial with both contracts (over 70% ),
as in previous studies for the FTSE-100 (see Holmes,
1995, 1996). Thus, hedging eŒectiveness improves as
62 D. Butterworth and P. Holmes
Table 1. The hedging eVectiveness of the FTSE-100 and FTSE-
Mid 250 contracts: dail y data
Hedge Mean S.D. of Decrease
ratio return returns in S.D.*
Cash portfolio
(A) Unhedged
FTSE 100 7.669 10.912
FTSE 250 4.464 6.999
FTSE 350 6.937 9.737
FTIT 1.691 8.138
(B) Hedging with the

FTSE100 contract
Traditional hedge
FTSE 100 1.000 ¡0.146 3.924 64.038
FTSE 250 1.000 ¡3.351 9.296 ¡32.816
FTSE 350 1.000 ¡0.878 4.805 50.651
FTIT 1.000 ¡6.124 9.112 ¡11.971
Beta hedge
FTSE 100 1.000 ¡0.146 3.924 64.038
FTSE 250 0.503 0.533 5.005 28.491
FTSE 350 0.888 ¡0.003 3.755 61.436
FTIT 0.586 ¡2.889 5.884 27.689
(C) Hedging with the
FTSE-Mid 250 contract
Traditional hedge
FTSE 100 1.000 3.293 6.938 36.422
FTSE 250 1.000 0.087 3.836 45.192
FTSE 350 1.000 2.560 5.681 41.651
FTIT 1.000 ¡2.686 5.506 32.337
Beta hedge
FTSE 100 1.223 2.317 7.064 35.264
FTSE 250 1.000 0.087 3.836 45.192
FTSE 350 1.172 1.808 5.875 39.657
FTIT 0.961 ¡2.515 5.410 33.520
Note: *This measures the percentage of the standard deviation of
returns of the unhedged portfolio that is removed by hedging.
Table 2. The hedging eVectiveness of the FTSE-10 0 an d FTSE-
Mid 250 contracts: weekly data
Hedge Mean S.D. of Decrease
ratio return returns in S.D.*
Cash portfolio

(A) Unhedged
FTSE 100 7.687 11.169
FTSE 250 4.474 9.276
FTSE 350 6.953 10.469
FTIT 1.695 9.027
(B) Hedging with the
FTSE 100 contract
Traditional hedge
FTSE 100 1.000 ¡0.020 2.500 77.613
FTSE 250 1.000 ¡0.466 7.398 20.254
FTSE 350 1.000 ¡0.122 3.266 68.800
FTIT 1.000 ¡0.851 7.222 19.991
Beta hedge
FTSE 100 1.000 ¡0.020 2.500 77.613
FTSE 250 0.695 ¡0.134 5.606 39.566
FTSE 350 0.932 ¡0.048 2.752 73.711
FTIT 0.678 ¡0.501 5.270 41.621
(C) Hedging with the
FTSE-Mid 250 contract
Traditional hedge
FTSE 100 1.000 0.458 5.717 48.811
FTSE 250 1.000 0.012 2.610 71.868
FTSE 350 1.000 0.356 4.523 56.794
FTIT 1.000 ¡0.373 4.789 46.952
Beta hedge
FTSE 100 1.008 0.453 5.720 48.800
FTSE 250 1.000 0.012 2.610 71.868
FTSE 350 1.006 0.352 4.527 56.755
FTIT 0.843 ¡0.278 4.424 50.994
Note: *As Table 1.

hedge duration rises. For cross hedges, the new contract
again achieves superior risk reduction for the FTIT (47%
compared to 20% for the FTSE-100 contract).
Tables 3 and 4 report daily and weekly results respect-
ively for the mean and standard deviation of returns using
the MVHR and LTS hedge ratio (LTSHR). Results
relate to the same cash portfolios as in Tables 1 and 2.
For convenience panel A again shows details of unhedged
positions. Panels B and C show results for hedging with the
FTSE-100 and Mid250 contract respectively. Panel D
reports results for the `synthetic’ FTSE-350 contract. In all
cases the results for the MVHR are reported ® rst, followed
by the results for the LTSHR. Results are als o reported for
the optimal combination of the two contrac ts.
9
The opti-
mal combinations of the FTSE-100 and Mid250 contracts
for daily data for the four cash portfolios are 0.75 : 0.25
(FTSE-100), 0 : 1 (Mid250), 0.75 : 0.2 5 (FTSE-350) and
0.25 : 0.75 (FTIT). Thus, for example, in constructing a
synthetic futures which minimizes the return variance
when hedging the FTIT portfolio, the optimal mix involves
a weighting of 0.25 in the FTSE100 contract and 0.75 in the
new contract. First, the MVHR results for daily and
weekly hedges are discussed and then these are compared
with the LTSHR results.
In relation to the MVHR, Table 3, panel B shows the
FTSE-100 contract greatly reduces risk for the FTSE-100
(73% ) and FTSE-350 (70% ) cash portfolios for daily hedges.
For the other portfolios risk reduction of only about 30% is

achieved. The Mid250 contract is less successful at reducing
risk for the FTSE-100 and FTSE-350 cash portfolios, as
expected, given that the FTSE-100 dominates these indexes
by market capitalization. However, for the other portfolios
the new contract is superior for hedging. Risk reduction of
52% and 36% is achieved for the Mid250 and FTIT cash
portfolios. Thus, for portfolios with smaller capitalization
the new contract is a signi® cant additional hedging facility.
Results in relation to the construction of a synthetic
futures are very interesting (see panel D). In all cases,
the optimal combination involves some use of the new
contract, while for the Mid250 cash portfolio the
FTSE-100 contract shoul d not be used. Thus, even fo r
the FTSE-100 cash portfolio, the introduction of the new
contract adds to hedging eŒectiveness.
10
In Table 4, once again hedging performance improves as
hedge duration rises to a week. However, the main results
are unchanged: for the FTSE-100 and FTSE-350 portfo-
lios, the FTSE-100 contract provide s higher risk reduction
than the Mid250 contract, with the new contract superior
for other cash portfolios. Optimal combinations for the
synthetic contract are the same as for daily data. Thus,
Hedging eVectiveness for cross hedges 63
Table 3. Hedging eVectiveness using the MVHR and LTSHR stra-
tegies: daily data
Hedge Mean S.D. of Decrease
ratio return returns in S.D.*
Cash portfolio
(A) Unhedged

FTSE 100 7.669 10.911
FTSE 250 4.464 6.998
FTSE 350 6.937 9.736
FTIT 1.691 8.137
(B) Hedging with
the FTSE 100 contract
MVHR
FTSE 100 0.803 1.392 2.960 72.875
FTSE 250 0.391 1.411 4.784 31.638
FTSE 350 0.710 1.390 2.944 69.765
FTIT 0.451 ¡1.831 5.612 31.034
LTSHR
FTSE 100 0.810 1.341 2.961 72.864
FTSE 250 0.361 1.646 4.800 31.409
FTSE 350 0.712 1.372 2.944 69.764
FTIT 0.415 ¡1.550 5.632 30.793
(C) Hedging with the
FTSE Mid 250 contract
MVHR
FTSE 100 1.050 3.069 6.926 36.513
FTSE 250 0.766 1.111 3.343 52.239
FTSE 350 0.985 2.630 5.682 41.648
FTIT 0.779 ¡1.711 5.209 35.987
LTSHR
FTSE 100 1.099 2.856 6.937 36.411
FTSE 250 0.784 1.031 3.346 52.192
FTSE 350 1.028 2.445 5.692 41.545
FTIT 0.735 ¡1.520 5.221 35.842
(D) Composite hedges**
MVHR

FTSE 100 0.924 1.245 2.882 73.589
FTSE 250 0.766 1.111 3.343 52.239
FTSE 350 0.823 1.211 2.609 73.205
FTIT 0.743 ¡2.201 4.892 39.887
LTSHR
FTSE 100 0.927 1.220 2.882 73.587
FTSE 250 0.784 1.031 3.346 52.192
FTSE 350 0.827 1.184 2.609 73.201
FTIT 0.699 ¡1.971 4.907 39.701
Note: *As Table 1.
**Results are reported for the optimal combination of FTSE-100
and FTSE-Mid 250 contract in terms of maximum risk reduction.
The optimal combinations are 0.75 : 0.25, 0:1, 0.75 : 0.25 and
0.25 : 0.75 respectively.
9
All other combinations identi® ed in the previous section were used to identify the optimal mix. The results for the other combinations
are available from the authors o n request.
10
This ® nding can, in part, be explained by the fact that the co mposition of the two cash indexes is revised on a regular basis re¯ ecting
changes in market capitalization. When changes are made, some stocks move out of the FTSE-100 into the Mid250 and others make the
move in the opposite direction.
the new contract improves hedging eŒectiveness even when
the cash portfolio is that underlyin g the FTSE-100 con-
tract.
Tables 3 and 4 also provide an opportunity to compare
the daily and weekly hedging results for the MVHR and the
LTSHR when the cash portfolios consist of stock market
indexes. It is clear that when the cash portfolios are broad
based market indexes trimming the sample to remove the
largest 10% of outliers tends to result in very small changes

to the si ze of the optimal hedge ratio and levels of risk
reduction. For instance, in the case of the hedge between
the FTSE 100 contract and the FTSE 100 index (Table 3,
panel B), the hedge ratio changes from 0.803 to 0.810 and
the level of ris k reduction falls from 72.875% to 72.864% .
For the cross hedges involving the FTSE 100 contract, the
diŒerences between the MVHR and LTSHR remain small
with the level of risk reduction being achieved by the
LTSHR being within 0.3% of the MV HR. In the case of
the Mid250 contract (Table 3, panel C), the diŒerence
between the MVHRs and the LTSHRs are of a similar
magnitude to those involving the FTSE 100 contract with
the diŒerences in the size of the hedge ratios being less than
0.05 and diŒerence in the levels of risk reduction being less
than 0.2% .
When hedges of weekly duration are considered (Table
4), the MVHRs and the LTSHRs are extremely similar,
with the LTSHRs approaching those of the MVHR strat-
egy . For the hedge between the FTSE 100 contract and
FTSE 100 index, the MVHR and LTSHR are 0.882 and
0.881, and levels of risk reduction are 81.860% and
81.859% respectively. Similarly, in the case of the hedge
between the Mid250 contract and the Mid250 index, the
MVHR and LTSHR are 0.918 and 0.928, and levels of risk
reduction are 73.228% and 73.0% respectively. Hence it is
clear that when the cash and futures series are highly cor-
related removing the largest 10% of outliers makes little
impact on hedging performance, demonstrating that the
hedge ratios estimated by OLS are indeed robust.
Investment trust companies

The hedging eŒectiveness of the two contracts when the
cash portfolios are ITCs is now examined . Given the super-
iority of the MVHR and LTSHR strategies, only those
strategies are considered. Rather than report results for
each of the thirty-two portfolios, average results for each
category of ITCs
11
are reported. Tables 5 and 6 report
result s for ITCs for daily and weekly hedges respectively.
The format of the tables is similar to Tables 3 and 4.
However, in addition to showing average risk reduction
for each category of ITC, maximum and minimum stan-
dard deviations for each category are also shown.
Panel A in both tables demonstrates that the cash port-
folios vary substantially in terms of mean and standard
64 D. Butterworth and P. Holmes
Table 4. Hedging eVectiveness using the MVHR and LTSHR stra-
tegies: daily data
Hedge Mean S.D. of Decrease
ratio return returns in S.D.*
Cash portfolio
(A) Unhedged
FTSE 100 7.687 11.169
FTSE 250 4.474 9.276
FTSE 350 6.953 10.469
FTIT 1.695 9.027
(B) Hedging with the
FTSE 100 contract
MVHR
FTSE 100 0.882 0.778 2.026 81.860

FTSE 250 0.601 ¡0.233 5.483 40.895
FTSE 350 0.819 0.538 2.367 77.390
FTIT 0.595 ¡2.966 5.166 42.765
LTSHR
FTSE 100 0.881 0.784 2.026 81.859
FTSE 250 0.575 ¡0.033 5.492 40.795
FTSE 350 0.808 0.622 2.371 77.352
FTIT 0.563 ¡2.718 5.181 42.603
(C) Hedging with the
FTSE Mid 250 contract
MVHR
FTSE 100 0.985 3.366 5.715 48.827
FTSE 250 0.918 0.447 2.483 73.228
FTSE 350 0.970 2.698 4.514 56.885
FTIT 0.809 ¡1.854 4.411 51.134
LTSHR
FTSE 100 0.984 3.369 5.715 48.827
FTSE 250 0.928 0.402 2.486 73.205
FTSE 350 0.995 2.587 4.521 56.820
FTIT 0.764 ¡1.655 4.433 50.894
(D) Composite hedges**
MVHR
FTSE 100 0.959 1.001 1.975 82.317
FTSE 250 0.918 0.447 2.483 73.228
FTSE 350 0.900 0.678 1.794 82.863
FTIT 0.795 ¡2.477 4.173 53.775
LTSHR
FTSE 100 0.957 1.017 2.013 81.975
FTSE 250 0.928 0.402 2.486 73.205
FTSE 350 0.896 0.705 1.795 82.858

FTIT 0.792 ¡2.464 4.173 53.774
Note: *As Table 1.
**Results are reported for the optimal combination of FTSE-100
and FTSE-Mid 250 contract in terms of maximum risk reduction.
The optimal combinations are 0.75:0.25, 0:1, 0.75:0.25 and
0.25:0.75 respectively.
11
Results in relation to trad itional and beta hedge strategies and those relating to individual investment trust companies are available on
request.
Hedging eVectiveness for cross hedges 65
Table 5. Hedging investment trusts portfolios using the MVHR and LTSHR strategies: daily data
Standard deviation of returns
Average Average
hedge ratio mean return Minimum Maximum Average Decrease*
Cash portfolio
(A) U nhedged portfolio
General 5.905 8.651 13.974 10.675
Capital growth 3.362 8.260 12.525 9.555
Income growth 0.553 7.664 11.924 9.878
High income ¡5.079 8.927 13.896 10.681
Small company 1.880 6.743 12.409 9.742
Venture/development 11.535 6.707 9.602 8.111
Property ¡7.579 13.496 13.883 13.690
(B) Hedging with the
FTSE 100 contract
MVHR
General 0.459 2.319 7.721 11.291 8.767 17.369
Capital growth 0.237 1.512 8.014 11.684 8.969 5.911
Income growth 0.343 ¡2.131 7.251 10.804 8.719 11.118
High income 0.278 ¡7.252 8.532 13.037 10.037 5.963

Small company 0.233 0.060 6.641 11.037 9.202 5.050
Venture/development 0.159 10.293 6.610 9.345 7.786 3.777
Property 0.186 ¡9.036 13.019 13.821 13.420 1.995
LTSHR
General 0.405 2.739 7.784 11.331 8.799 17.051
Capital growth 0.184 1.925 8.024 11.759 9.004 5.563
Income growth 0.285 ¡1.677 7.273 10.823 8.758 10.700
High income 0.206 ¡6.686 8.553 13.063 10.086 5.493
Small company 0.167 0.573 6.670 11.054 9.245 4.587
Venture/development 0.117 10.618 6.623 9.363 7.806 3.539
Property 0.166 ¡8.876 13.033 13.821 13.427 1.940
(C) He dging with the
FTSE Mid 250 contract
MVHR
General 0.832 2.263 7.231 10.811 8.299 21.945
Capital growth 0.497 1.191 7.467 11.338 8.631 9.551
Income growth 0.658 ¡2.326 7.059 10.536 8.252 15.781
High income 0.571 ¡7.570 8.334 12.465 9.638 9.638
Small company 0.478 ¡0.208 6.447 10.817 8.924 7.968
Venture/development 0.332 10.082 6.472 9.079 7.615 5.815
Property 0.490 ¡9.719 12.660 13.512 13.086 4.435
LTSHR
General 0.783 2.478 7.267 10.832 8.316 21.763
Capital growth 0.403 1.603 7.556 11.364 8.669 9.123
Income growth 0.551 ¡1.859 7.105 10.556 8.312 15.099
High income 0.421 ¡6.911 8.401 12.500 9.718 8.853
Small company 0.344 0.377 6.499 10.865 8.990 7.275
Venture/development 0.237 10.495 6.502 9.171 7.655 5.334
Property 0.427 ¡9.443 12.672 13.520 13.096 4.363
(D) Composite hedgesy

MVHR
General 0.804 2.048 7.216 10.544 8.142 23.277
Capital growth 0.490 1.115 7.465 11.334 8.610 9.746
Income growth 0.625 ¡2.573 7.060 10.458 8.205 16.210
High income 0.562 ¡7.633 8.334 12.465 9.636 9.660
Small company 0.473 ¡0.270 6.429 10.689 8.896 8.228
Venture/development 0.328 10.057 6.469 9.075 7.599 6.006
Property 0.507 ¡9.427 12.660 13.412 13.036 4.796
LTSHR
General 0.708 2.493 7.225 10.583 8.215 22.539
Capital growth 0.404 1.497 7.554 11.351 8.645 9.344
Income growth 0.506 ¡2.010 7.106 10.471 8.283 15.322
High income 0.405 ¡6.913 8.401 12.501 9.729 8.753
Small company 0.337 0.327 6.493 10.731 8.967 7.467
Venture/development 0.231 10.477 6.505 9.167 7.641 5.498
Property 0.410 ¡9.112 12.671 13.454 13.063 4.603
Notes: * The decrease in the S.D. of returns relates to a comparison of the average S.D. of returns for the hedged position with that of the unhedged position.
y The optimal combinations of the FTSE-100 and FTSE-Mid 250 contract range from 0.25:0.7 5 to ¡0.5 to 1.5. For no portfolio did the weight given to the
FTSE-Mid 250 contract fall below 0.75.
66 D. Butterworth and P. Holmes
Table 6. Hedging investment trusts portfolios using the MVHR and LTSHR strategies: weekly data
Standard deviation of returns
Average Average
hedge ratio mean return Minimum Maximum Average Decrease*
Cash portfolio
(A) U nhedged portfolio
General 5.919 10.870 13.604 11.816
Capital growth 3.370 10.403 13.546 11.568
Income growth 0.554 9.992 14.124 11.894
High income ¡5.091 10.764 15.406 12.785

Small company 1.885 8.890 14.456 11.990
Venture/development 11.561 7.961 10.857 9.347
Property ¡7.596 16.393 17.599 16.996
(B) Hedging with the
FTSE 100 contract
MVHR
General 0.623 1.037 6.785 9.865 8.784 25.429
Capital growth 0.381 0.385 9.290 12.004 10.471 9.343
Income growth 0.532 ¡3.616 8.228 11.014 9.746 17.882
High income 0.486 ¡8.901 9.583 13.660 11.226 12.262
Small company 0.435 ¡1.521 8.591 12.633 10.640 10.837
Venture/development 0.259 9.531 7.485 9.930 8.684 6.794
Property 0.509 ¡11.583 15.585 15.766 15.676 7.632
LTSHR
General 0.594 1.266 6.800 9.869 8.803 25.255
Capital growth 0.329 0.793 9.290 12.099 10.503 9.086
Income growth 0.487 ¡3.263 8.276 11.042 9.775 17.630
High income 0.449 ¡8.605 9.629 13.662 11.247 12.086
Smallcompany 0.367 ¡0.993 8.628 12.671 10.683 10.486
Venture/development 0.225 9.796 7.515 9.991 8.706 6.571
Property 0.357 ¡10.394 15.699 15.879 15.789 6.966
(C) He dging with the
FTSE Mid 250 contract
MVHR
General 0.864 2.127 6.920 9.960 8.243 30.279
Capital growth 0.586 0.798 8.754 11.762 9.941 13.910
Income growth 0.785 ¡2.887 7.852 10.074 9.052 23.639
High income 0.705 ¡8.182 9.215 13.227 10.746 16.031
Small company 0.672 ¡1.063 8.060 12.205 10.009 16.263
Venture/development 0.391 9.846 7.290 9.725 8.486 8.953

Property 0.776 ¡11.000 15.153 15.190 15.171 10.618
LTSHR
General 0.792 2.446 6.954 9.960 8.291 29.857
Capital growth 0.470 1.309 8.853 11.909 10.022 13.231
Income growth 0.664 ¡2.357 7.934 10.233 9.150 22.823
High income 0.576 ¡7.616 9.288 13.243 10.831 15.325
Smallcompany 0.534 ¡0.458 8.184 12.276 10.111 15.392
Venture/development 0.308 10.210 7.362 9.771 8.529 8.462
Property 0.523 ¡9.889 15.290 15.463 15.376 9.397
(D) Composite hedgesy
MVHR
General 0.853 1.556 6.268 9.617 8.036 31.974
Capital growth 0.588 0.867 8.596 11.706 9.868 14.525
Income growth 0.779 ¡3.165 7.750 10.055 8.960 24.431
High income 0.693 ¡8.359 9.215 13.205 10.735 16.122
Small company 0.673 ¡1.059 7.902 12.174 9.971 16.662
Venture/development 0.385 10.022 7.290 9.708 8.556 8.282
Property 0.773 ¡11.091 15.110 15.136 15.123 10.905
LTSHR
General 0.829 1.667 6.276 9.622 8.045 31.890
Capital growth 0.520 1.103 8.684 11.715 9.907 14.191
Income growth 0.694 ¡2.796 7.757 10.102 9.021 23.913
High income 0.662 ¡8.198 9.216 13.217 10.747 16.027
Small company 0.607 ¡0.806 8.002 12.180 10.010 16.290
Venture/development 0.310 10.326 7.381 9.744 8.599 7.779
Property 0.610 ¡10.481 15.116 15.379 15.248 10.144
Note: * The decrease in the S.D. of returns relates to a c omparison the average S.D. of returns for the hedged position with that of the unhedged position.
y The optimal combinations of the FTSE-100 and FTSE-Mid 250 contract range from 0.5:0. 5 to ¡0.75 to 1.75. For no portfolio did the weight given to the
FTSE-Mid 250 contract fall below 0.5.
deviations of returns. Thus, the 32 portfolios under con-

sideration cover a broad range of cash portfolios, provid-
ing an opportunity for a thorough assessment of true hedge
eŒectiveness. As can be seen in Table 5, panels B and C, in
all cases average standard deviation of returns is lower
when a MVHR strategy using the Mid250 contract is
used compared to using the FTSE-10 0 contract. The
same is true for weekly hedges (see Table 6), providing
strong evidence in support of the usefulness of the
Mid250 contract for hedging actual cash portfolios.
However, while the results show the superiority of the
Mid250 contract for hedging these cash portfolios, risk
reduction is far less than when cash portfolios are broad
market indexes. For example, for daily hedges, in no case
does average risk reduction exceed 22% for the ITC port-
folios and even when using the Mid250 contract, average
reduction is below 10% for ® ve categories. This compares
with risk reduction for broad market indexes of 36% ± 52%
when the Mid250 contract is used and up to 73% fo r the
FTSE-100 contract. The results for SC funds and VDC
funds are particularly weak, suggesting that while the new
contract relates to an index covering smaller companies,
it is still not suitable for hedging portfolios comprising
very low value stocks. Results for weekly hedges are mark-
edly better. In only one case is average risk reduction below
10% when using the Mid250 contract (three when using the
FTSE-100 contract) and average risk reduction of almost
one third is achieved for the General funds using the new
contract.
Results for the optimal synthetic futures show minor
improvement over results for the Mid250 contract. In all

cases the optimal combination involves using the Mid250
contract, again supporting the view that the new contract
has an important role to play, particularly in relation to
hedging portfolios which are not broadly diversi ® ed.
The results in Tables 5 and 6 allow us to compare the
hedging eŒectiveness of the MVHR and LTSHR when the
cash portfolios are ITCs. It is apparent that when the cash
portfolios are ITCs, removing the largest 10% of outliers
has a more signi® cant eŒect on the optimal hedge ratio
than in the case where the cash portfolios are stock market
indexes. For both the FTSE 100 and Mid250 contracts
(Tables 5 and 6, panels B and C), trimming away the
10% most extreme observations alters the average size of
the hedge rati o by 6± 28% for daily hedges and by 5± 33%
for weekly hedges. In al l but ® ve cases the diŒerence is 10%
or greater. Generally, the percentage variations in the esti-
mated hedge ratios are higher for daily hedges than weekly
hedges.
12
However, while the MVHRs are noticeably larger
than the LTSHRs, the levels of risk reduction achieved by
both strategies remain similar. For all ITC categories, the
LTSHR achieves levels of risk reduction which are within
0.7% of the MVHR when the FTSE 100 contract is used,
and within 1.3% of the MVHR when the Mid 250 contract
is used. However, the results for ITCs sugges t that outliers
do impact on estimated hedge ratios. Given that there is no
reason to expect outliers in one period to be repeated in a
subsequent period, it is important to give consideration to
the way in which hedge ratios are estimated for portfolios

which do not mirror a broad market i ndex. In particular,
when ex ante hedge ratios are to be determined on the basis
of estimations using historical data, it may be desirable to
consider using the LTS approach.
13
V. SU MMA R Y AND C ONCL U S I O N S
This paper provides the ® rst assessment of hedging per-
formance of the Mid250 futures contract. Given the low
level of trading in this contract hedging eŒectiveness may
be limited. T he paper also provides the ® rst examination of
hedging eŒectiveness of stock index futures when the cash
portfolio to be hedged is an actual portfolio, rather than a
broad market index or a portfolio speci® cally constructed
for the purposes of research. Thus, it provides the ® rst true
assessment of hedging eŒectiveness in practice.
Results demonstrate that in spite of low trading volume,
the Mid250 contract provides an important additional hed-
ging instrument. The ® ndings in relatio n to hedging broad
market indexes show the superiority of the new contract
over the FTSE-100 contract in relation to cash portfolios
mirroring the Mid250 and the FTIT indexes. When con-
sidering actual cash portfolios in the form of ITCs, the
result s clearly demonstrate the bene® ts to be gained from
using the new contract. In all cases, the average standard
deviation of returns is lower when the Mid250 contract is
used as compared to the use of the FTSE-100 contract.
Results also show that previous studies of hedging eŒec-
tiveness have greatly exaggerated the risk reduction which
can be achieved. While previous studies for the UK have
found risk reduction of 60% to 80 % , this study shows that

for many portfolios, including those comprising smaller
stocks, risk reduction of below 20% is achieved. Thus,
while the new contract does signi® cantly add to the ability
to hedge risk, for many portfolios there is still no satisfac-
tory means by which to achieve substantial risk reduction.
Finally, the ® ndings in the paper indicate that when the
cash indexes are broad stock market indexes the MVHR is
a robust estimator and that hedge eŒectiveness is not
strongly aŒected by the presence of outliers. However,
Hedging eVectiveness for cross hedges 67
12
The exceptions to this are the results for the property funds for both contracts and the general fund for the Mid250 contract.
13
The results presented here sugges t that an examination of ex ante hedging eŒectiveness when using MVHRs and LTSHRs is worthy of
consideration. Such an investigation is beyond the scope of this current paper.
when ITCs are considered, outliers do impact noticeably
on estimated hedge ratios and as a result consideration
should be given to using the LTS method of estimation.
ACK NOW LED GEM E N TS
The authors gratefully acknowledge the helpful comments
of Professor Denis O’Brien, Professor Ron Smith of
Birbeck College, Jonathan Rougier, Alberto Carparni of
London Economics and an anonymous referee from
Applied Financial Economics. They are also grateful to
Austin McCarthy for help with the data colle ction. The
usual disclaimer applies.
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