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Potential Welfare Gains from Optimal Macro Hedging for Oil Exporters

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  • Ricardo Lalloo

    (The Department of Economics, The University of the West Indies, St. Augustine, Trinidad and Tobago)

Abstract

This paper computes the welfare gains from optimal hedging with futures contracts for an oil-exporting country. Unlike previous studies, this paper derives the welfare gains under a more realistic futures hedging model. This is accomplished by considering basis risk and by relaxing the full-hedging assumption. Furthermore, this is the first paper to derive the welfare gains under optimal hedging strategies. We also incorporate the empirical relationship between spot and futures prices within our models, rather than the theoretical relationship which most studies employ. The models were developed under a dynamic stochastic optimization framework and the optimal consumption and value functions were found using the method of Endogenous Gridpoints. The results showed that the choice of the optimal hedging strategy employed led to a slight improvement in the country’s welfare gains relative to full hedging. We also found that the strategies with the highest welfare gains were the most effective at volatility reduction. Finally, this paper provides compelling evidence for the use of optimal macro futures hedging as an effective risk management tool for oil-exporting developing countries.

Suggested Citation

  • Ricardo Lalloo, 2023. "Potential Welfare Gains from Optimal Macro Hedging for Oil Exporters," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-22, September.
    • Handle: RePEc:wsi:afexxx:v:18:y:2023:i:03:n:s2010495223500069
    DOI: 10.1142/S2010495223500069
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    More about this item

    Keywords

    Optimal hedging; welfare; consumption; futures contracts; oil;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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