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Minimum variance hedging when spot price changes are partially predictable

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  • Ederington, Louis H.
  • Salas, Jesus M.
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    Abstract

    In many markets, changes in the spot price are partially predictable. We show that when this is the case: (1) although unbiased, traditional regression estimates of the minimum variance hedge ratio are inefficient, (2) estimates of the riskiness of both hedged and unhedged positions are biased upward, and (3) estimates of the percentage risk reduction achievable through hedging are biased downward. For natural gas cross hedges, we find that both the inefficiency and bias are substantial. We further find that incorporating the expected change in the spot price, as measured by the futures-spot price spread at the beginning of the hedge, into the regression results in a substantial increase in efficiency and reduction in the bias.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 32 (2008)
    Issue (Month): 5 (May)
    Pages: 654-663

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    Handle: RePEc:eee:jbfina:v:32:y:2008:i:5:p:654-663

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    Web page: http://www.elsevier.com/locate/jbf

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    1. Lien, Donald & Tse, Y K, 2002. " Some Recent Developments in Futures Hedging," Journal of Economic Surveys, Wiley Blackwell, vol. 16(3), pages 357-96, July.
    2. Hilliard, Jimmy E, 1984. " Hedging Interest Rate Risk with Futures Portfolios under Term Structure Effects," Journal of Finance, American Finance Association, vol. 39(5), pages 1547-70, December.
    3. Kroner, Kenneth F. & Sultan, Jahangir, 1993. "Time-Varying Distributions and Dynamic Hedging with Foreign Currency Futures," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(04), pages 535-551, December.
    4. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March.
    5. Donald Lien & Y. K. Tse & Albert Tsui, 2002. "Evaluating the hedging performance of the constant-correlation GARCH model," Applied Financial Economics, Taylor & Francis Journals, vol. 12(11), pages 791-798.
    6. Fama, Eugene F & French, Kenneth R, 1987. "Commodity Futures Prices: Some Evidence on Forecast Power, Premiums,and the Theory of Storage," The Journal of Business, University of Chicago Press, vol. 60(1), pages 55-73, January.
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    Cited by:
    1. Rozaimah Zainudin & Roselee Shah Shaharudin, 2011. "Multi Mean Garch Approach to Evaluating Hedging Performance in the Crude Palm Oil Futures Market," Asian Academy of Management Journal of Accounting and Finance, Penerbit Universiti Sains Malaysia, vol. 7(1), pages 111-130.
    2. Caporin, Massimiliano, 2013. "Equity and CDS sector indices: Dynamic models and risk hedging," The North American Journal of Economics and Finance, Elsevier, vol. 25(C), pages 261-275.
    3. Thomas Conlon & John Cotter & Ramazan Gencay, 2012. "Commodity futures hedging, risk aversion and the hedging horizon," Working Papers 201218, Geary Institute, University College Dublin.
    4. Torro, Hipolit, 2009. "Assessing the influence of spot price predictability on electricity futures hedging," MPRA Paper 18892, University Library of Munich, Germany.
    5. Lee, Hsiang-Tai, 2010. "Regime switching correlation hedging," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2728-2741, November.
    6. Mihaela NICOLAU & Giulio PALOMBA & Ilaria TRAINI, 2013. "Are Futures Prices Influenced by Spot;Prices or Vice-versa? An Analysis of Crude;Oil, Natural Gas and Gold Markets," Working Papers 394, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
    7. Fu, Junhui, 2014. "Multi-objective hedging model with the third central moment and the capital budget," Economic Modelling, Elsevier, vol. 36(C), pages 213-219.
    8. Zanotti, Giovanna & Gabbi, Giampaolo & Geranio, Manuela, 2010. "Hedging with futures: Efficacy of GARCH correlation models to European electricity markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(2), pages 135-148, April.

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