The present study attempts to suggest an optimal hedge ratio for Indian traders through the examination of three indices, i.e., Nifty, Bank Nifty and CNXIT, and 84 most liquid individual stock futures traded on the National Stock Exchange of India, over the sample period January 2003 to December 2006. The present study compares the efficiency of hedge ratios estimated through OLS, VAR, VECM, GARCH(p,q), TARCH(p,q) and EGARCH(p,q) in the minimum variance hedge ratio framework, as suggested by Ederington (1979). The Findings of the present study conform to the theoretical properties of futures markets and suggest that unconditional hedge ratio, after controlling for basis risk, outperforms the conditional hedge ratio. The results favor the hedge ratios estimated through VAR or VECM because both the markets are cointegrated in Engle and Granger (1987) framework, and the findings are consistent with that of Alexander (1999).

Existence of organized futures markets furnishes an opportunity to legitimate traders to hedge the non-diversifiable risk element contained in their portfolios and help informed market participants to speculate on basis risk, so that they can secure risk-free profit, which is offered as a reward to restore market equilibrium. The reward to restore market equilibrium arises due to noise trading by uninformed market agents, which raises the degree of information asymmetry in the underlying asset market and initiates trading at disequilibrium price (which is reflected through jumps in the basis risk) (Cox, 1976; Danthine, 1978; Carlton, 1984; Hodgson and Nicholls, 1991; Castelino, 1992; Mckenzie et al., 2001; Chatrath et al., 2003; and Illueca and Lafuente, 2003). On the other hand, informed trading by market agents is expected to bring fairness in price change of the underlying asset and helps it to stabilize, consequently the required rate of return will decline (Bessembinder and Seguin, 1992; and Gulen and Mayhew, 2000). Therefore, an organized futures market is a joint product, where portfolio risk insurance is furnished to hedgers, gambling to speculators, and arbitrageurs undertake the responsibility to restore the market equilibrium (Telser, 1981).

Academic literature has widely appreciated the information transmission role of futures markets, which implies that price movement in futures market can be efficiently used to price cash market transactions (Cox, 1976; Peck, 1976; Telser, 1981; Garbade and Sibler, 1983; and Carlton, 1984). Since both the markets are linked through an efficient arbitrage process (Garbade and Sibler, 1983; and Mackinlay and Ramaswamy, 1988), convergence of both markets on the maturity date is natural (Figure 1). However, they may deviate from each other during the short run.

Financial Risk Management Journal, National Stock Exchange, NSE, Conventional Hedging Theory, Portfolio Hedging Theory, Hedge Ratio, Corporate Actions, Augmented Dickey-Fuller, ADF, Autoregressive Conditional Heteroscedasticity, ARCH, Securities and Exchange Board of India, SEBI.