Stock index hedging using a trend and volatility regime-switching model involving hedging cost

In this study, the risk hedge between the Morgan Stanley Taiwan stock index (MSTI) and its underlying futures is analyzed regarding hedging cost under various hedge states using the trend and volatility involved regime-switching models compared with OLS and the naive method. The correlation between MSTI spot and futures is very high and the cointegration test between them is very significantly. The hedging result is evaluated using out-of-sample data and the realized variances and covariances, and is really satisfying in the subprime period or when both spot and future stay in a down state. In this stock index context, the risk aversion is determined to be 1. The optimal hedge ratio on average is around 0.878. The White test favors the regime-switching models in prediction. The trend and volatility-switching model performs particularly well in wealth increase.