The hedge ratio and the empirical relationship between the stock and futures markets: A new approach using wavelet analysis

This paper examines the relationship between the stock and futures markets in terms of lead-lag relationship, correlation, and the hedge ratio using wavelet analysis. Empirical results show that (1) there is a feedback relationship between the stock and futures markets regardless of time scales, (2) wavelet correlation between two markets varies over investment horizons but remains very high, and (3) hedge ratio and the effectiveness of hedging strategies increase as the wavelet time scale increases. Simulation for utility comparisons shows that hedging effectiveness depends not only on the time scale but also on the risk aversion coefficient of an individual investor.This paper examines the relationship between the stock and futures markets in terms of lead-lag relationship, correlation, and the hedge ratio using wavelet analysis. Empirical results show that (1) there is a feedback relationship between the stock and futures markets regardless of time scales, (2) wavelet correlation between two markets varies over investment horizons but remains very high, and (3) hedge ratio and the effectiveness of hedging strategies increase as the wavelet time scale increases. Simulation for utility comparisons shows that hedging effectiveness depends not only on the time scale but also on the risk aversion coefficient of an individual investor.