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Hedging under square loss

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  • Bloznelis, Daumantas

Abstract

The framework of minimum-variance hedging rests on a highly restrictive foundation. The objective of variance minimization is only justifiable when variance coincides with expected squared forecast error. Nevertheless, the classical framework is routinely applied when the condition fails, giving rise to inaccurate risk assessments and suboptimal hedging decisions. This study proposes a new, improved framework of hedging which relaxes the above condition at no tangible cost. It derives a new objective function, an optimal hedge ratio, and a measure of hedging effectiveness under square loss. Their superior performance is demonstrated from a theoretical standpoint and by applying them to hedging the price risk of oil and natural gas. Simple yet general, the new framework is well suited to replace the classical one and facilitates adequate risk measurement and improved hedging decisions. It also provides fundamental insight into dealing with uncertainty under square loss and beyond.

Suggested Citation

  • Bloznelis, Daumantas, 2017. "Hedging under square loss," MPRA Paper 83442, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:83442
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Minimum-variance hedging; hedging effectiveness; optimal hedge ratio; risk; uncertainty; square loss; forecast error;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • Q02 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - General - - - Commodity Market

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