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Comparing Hedging Effectiveness: An Application of the Encompassing Principle

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  • Sanders, Dwight R.
  • Manfredo, Mark R.

Abstract

An empirical methodology is developed for statistically testing the hedging effectiveness among competing futures contracts. The presented methodology is based on the encompassing principle, widely used in the forecasting literature, and applied here to minimum variance hedging regressions. Intuitively, the test is based on an alternative futures contract's ability to reduce residual basis risk by offering either diversification or a smaller absolute level of basis risk than a preferred futures contract. The methodology is easily extended to cases involving multiple hedging instruments and general hedge ratio models. Empirical applications suggest that the encompassing methodology can provide information beyond traditional approaches of comparing hedging effectiveness.

Suggested Citation

  • Sanders, Dwight R. & Manfredo, Mark R., 2004. "Comparing Hedging Effectiveness: An Application of the Encompassing Principle," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 29(1), pages 1-14, April.
    • Handle: RePEc:ags:jlaare:31136
    DOI: 10.22004/ag.econ.31136
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    9. Josué Martínez‐Garmendia & James L. Anderson, 1999. "Hedging performance of shrimp futures contracts with multiple deliverable grades," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 19(8), pages 957-990, December.
    10. Elam, Emmett W., 1988. "Estimated Hedging Risk With Cash Settlement Feeder Cattle Futures," Western Journal of Agricultural Economics, Western Agricultural Economics Association, vol. 13(1), pages 1-8, July.
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    Cited by:

    1. Manfredo, Mark R. & Richards, Timothy J., 2005. "Hedging Yield with Weather Derivatives: A Role for Options," 2005 Annual meeting, July 24-27, Providence, RI 19369, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    2. Dahlgran, Roger A., 2009. "Inventory and Transformation Hedging Effectiveness in Corn Crushing," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 34(1), pages 1-18, April.
    3. Revoredo-Giha, Cesar & Zuppiroli, Marco, 2013. "Commodity futures markets: are they an effective price risk management tool for the European wheat supply chain?," Bio-based and Applied Economics Journal, Italian Association of Agricultural and Applied Economics (AIEAA), vol. 2(3), pages 1-19, December.
    4. Tejeda, Hernan A., 2012. "Time-Varying Price Interactions and Risk Management in Livestock Feed Markets – Determining the Ethanol Surge Effect," 2012 Annual Meeting, August 12-14, 2012, Seattle, Washington 124956, Agricultural and Applied Economics Association.
    5. Franken, Jason R.V. & Irwin, Scott H. & Garcia, Philip, 2021. "Biodiesel hedging under binding renewable fuel standard mandates," Energy Economics, Elsevier, vol. 96(C).
    6. Brinker, Adam J. & Parcell, Joseph L. & Dhuyvetter, Kevin C. & Franken, Jason R.V., 2009. "Cross-Hedging Distillers Dried Grains Using Corn and Soybean Meal Futures Contracts," Journal of Agribusiness, Agricultural Economics Association of Georgia, vol. 27(1-2), pages 1-15.
    7. repec:ags:jrapmc:122315 is not listed on IDEAS
    8. Regmund, Wes & Robinson, John & Anderson, David, "undated". "Higher and More Stable Returns From Cottonseed," 2017 Annual Meeting, February 4-7, 2017, Mobile, Alabama 252813, Southern Agricultural Economics Association.
    9. Karali, Berna, 2012. "Do USDA Announcements Affect Comovements Across Commodity Futures Returns?," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 37(1), pages 1-21, April.
    10. Wang, Qizhi & Chidmi, Benaissa, 2009. "Cotton Price Risk Management across Different Countries," 2009 Annual Meeting, January 31-February 3, 2009, Atlanta, Georgia 46762, Southern Agricultural Economics Association.
    11. Marco Zuppiroli & Cesar Revoredo-Giha, 2016. "Hedging effectiveness of European wheat futures markets: an application of multivariate GARCH models," International Journal of Applied Management Science, Inderscience Enterprises Ltd, vol. 8(2), pages 132-148.
    12. Parcell, Joseph L. & Boessen, Christian R. & Altman, Ira J. & Sanders, Dwight R., 2008. "Cross-Hedging Fishmeal: Exploring Corn and Soybean Meal Futures Contracts," 2008 Annual Meeting, February 2-6, 2008, Dallas, Texas 6763, Southern Agricultural Economics Association.
    13. Power, Gabriel J. & Vedenov, Dmitry V., 2008. "The Shape of the Optimal Hedge Ratio: Modeling Joint Spot-Futures Prices using an Empirical Copula-GARCH Model," 2008 Conference, April 21-22, 2008, St. Louis, Missouri 37609, NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management.
    14. Brinker, Adam J. & Parcell, Joseph L. & Dhuyvetter, Kevin C., 2007. "Cross-Hedging Distillers Dried Grains: Exploring Corn and Soybean Meal Futures Contracts," 2007 Conference, April 16-17, 2007, Chicago, Illinois 37567, NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management.

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