Hedging the black swan: Conditional heteroskedasticity and tail dependence in S&P500 and VIX

• Published in: Journal of banking & finance Vol. 35; no. 9; pp. 2374 - 2387
• Main Authors: Hilal, Sawsan, Poon, Ser-Huang, Tawn, Jonathan
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.09.2011; Elsevier; Elsevier Sequoia S.A
• Series: Journal of Banking & Finance
• Subjects: Capital market; Dependence relationships; Downside risk; Extremal dependence structure; Extreme value theory; Financial crisis; Financial models; Financial theory; Financial time series; Financial time series Extreme value theory Extremal dependence structure Downside risk Optimal hedge ratio; Futures; Futures market; Hedging; Optimal hedge ratio; Studies; Time series; Valuation; United States > US; Extremal dependence structure; Optimal hedge ratio; Extreme value theory; C14; G13; Downside risk; C18; Financial time series
• ISSN: 0378-4266; 1872-6372
• DOI: 10.1016/j.jbankfin.2011.01.035

The recent financial crisis has accentuated the fact that extreme outcomes have been overlooked and not dealt with adequately. While extreme value theories have existed for a long time, the multivariate variant is difficult to handle in the financial markets due to the prevalent heteroskedasticity embedded in most financial time series, and the complex extremal dependence that cannot be conveniently captured by a single structure. Moreover, most of the existing approaches are based on a limiting argument in which all variables become large at the same rate. In this paper, we show how the conditional approach of Heffernan and Tawn (2004) can be implemented to model extremal dependence between financial time series. We use a hedging example based on VIX futures to demonstrate the flexibility and superiority of the conditional approach against the conventional OLS regression approach.