Testing the Hedging Effectiveness of Indian Equity and Currency Futures Contracts

Hedging is widely used as a risk-minimizing mechanism where hedgers invest simultaneously in cash and futures market, but in opposite direction, so that the price change in one market offsets price change in another market. Present study attempts to examine the hedging effectiveness of equity and currency futures contracts traded at National Stock Exchange of India, over the period January 2011 to December 2018. The sample size consists of three benchmark indices of equity futures market (i.e. NIFTY50, NIFTYIT and BANKNIFTY) and four currency futures contracts (i.e. USD, EURO, YEN and GBP). Optimal hedge ratios have been estimated by using five different methods. The findings suggest that equity futures market is more efficient as compared to currency futures market as variance reduction is found to be more than 95% in case of equity futures contracts; whereas in case of currency futures contracts, it is found to be less than 40%. Secondly, it is also found that for six (out of seven futures contracts understudy), hedging effectiveness is found to be highest using Ordinary Least Square (OLS) method, whereas for only NIFTYIT, it is found to be highest using Vector Autoregression (VAR) and Vector Error Correction model (VECM) methods of estimating optimal hedge ratio. Hence, the study also suggests that constant hedge ratios perform superior to time-varying hedge ratios.