The opportunity cost of hedging under incomplete information: Evidence from ETF/Ns

This paper considers the optimal hedge ratio problem under estimation risk. Due to incomplete information, the decision-maker evaluates the opportunity cost of hedging using exchange-traded funds or notes (ETF/Ns). Using a backtesting procedure over the last 5 years and 13 different hedging instruments—both inverse-equity ETFs and volatility ETNs—we quantify the proposed opportunity cost using different out-of-sample performance metrics. Given the greater accessibility of commission-free brokers for small investors along with the popularity of ETF/Ns, our paper appeals to retail investors and provides guidance in terms of choosing the optimal hedge ratio under estimation risk.