A Test of Equity Index Return Predictability Using Index Futures
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Hong and Yogo (2012) presents a theoretical framework, arguing that stock returns can be predicted via preceding futures market movements, to some extent, but the predictability is limited when the number of investors who want to hedge their portfolio positions in real asset class by using futures increases. We test, using KOSPI200 which is a stock index representing Korean stock market and which consists of 200 largest firms in the market, whether the preceding returns of equity index futures can predict the returns of the equity index returns and whether the predictability varies depending on the level of hedge demand in the market. we show that preceding futures return does not consistently predict equity index return, while there exists no systemic evidence that the predictability varies when the level of hedge demand is also considered. Test results are robust when virtual trading strategy buys and sells equity index based upon past day’s futures return, yielding close to zero trading profits. Our findings have implications towards Chief Executive Officers(CEOs) possessing firms’ equities as a part of their total monetary compensation, by saying that CEOs should be cautious relying on futures market in hedging the price volatility of their equity portfolio.
Abstract
Hong and Yogo (2012) presents a theoretical framework, arguing that stock returns can be predicted via preceding futures market movements, to some extent, but the predictability is limited when the number of investors who want to hedge their portfolio positions in real asset class by using futures increases. We test, using KOSPI200 which is a stock index representing Korean stock market and which consists of 200 largest firms in the market, whether the preceding returns of equity index futures can predict the returns of the equity index returns and whether the predictability varies depending on the level of hedge demand in the market. we show that preceding futures return does not consistently predict equity index return, while there exists no systemic evidence that the predictability varies when the level of hedge demand is also considered. Test results are robust when virtual trading strategy buys and sells equity index based upon past day’s futures return, yielding close to zero trading profits. Our findings have implications towards Chief Executive Officers(CEOs) possessing firms’ equities as a part of their total monetary compensation, by saying that CEOs should be cautious relying on futures market in hedging the price volatility of their equity portfolio.
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