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The (de)merits of minimum-variance hedging: Application to the crack spread

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  • Alexander, Carol
  • Prokopczuk, Marcel
  • Sumawong, Anannit

Abstract

We study the empirical performance of the classical minimum-variance hedging strategy, comparing several econometric models for estimating hedge ratios of crude oil, gasoline and heating oil crack spreads. Given the great variability and large jumps in both spot and futures prices, considerable care is required when processing the relevant data and accounting for the costs of maintaining and re-balancing the hedge position. We find that the variance reduction produced by all models is statistically and economically indistinguishable from the one-for-one “naïve” hedge. However, minimum-variance hedging models, especially those based on GARCH, generate much greater margin and transaction costs than the naïve hedge. Therefore we encourage hedgers to use a naïve hedging strategy on the crack spread bundles now offered by the exchange; this strategy is the cheapest and easiest to implement. Our conclusion contradicts the majority of the existing literature, which favours the implementation of GARCH-based hedging strategies.

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  • Alexander, Carol & Prokopczuk, Marcel & Sumawong, Anannit, 2013. "The (de)merits of minimum-variance hedging: Application to the crack spread," Energy Economics, Elsevier, vol. 36(C), pages 698-707.
  • Handle: RePEc:eee:eneeco:v:36:y:2013:i:c:p:698-707
    DOI: 10.1016/j.eneco.2012.11.016
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    Cited by:

    1. Martínez, Beatriz & Torró, Hipòlit, 2018. "Hedging spark spread risk with futures," Energy Policy, Elsevier, vol. 113(C), pages 731-746.
    2. Shi, Ruoding & Isengildina Massa, Olga, 2018. "Double-Edged Sword: Liquidity Implications of Futures Hedging," 2018 Annual Meeting, August 5-7, Washington, D.C. 274106, Agricultural and Applied Economics Association.
    3. Martínez, Beatriz & Torró, Hipòlit, 2015. "European natural gas seasonal effects on futures hedging," Energy Economics, Elsevier, vol. 50(C), pages 154-168.
    4. Furió, Dolores & Torró, Hipòlit, 2020. "Optimal hedging under biased energy futures markets," Energy Economics, Elsevier, vol. 88(C).
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    6. Olson, Eric & Vivian, Andrew & Wohar, Mark E., 2017. "Do commodities make effective hedges for equity investors?," Research in International Business and Finance, Elsevier, vol. 42(C), pages 1274-1288.
    7. Ewald, Christian-Oliver & Nawar, Roy & Siu, Tak Kuen, 2013. "Minimal variance hedging of natural gas derivatives in exponential Lévy models: Theory and empirical performance," Energy Economics, Elsevier, vol. 36(C), pages 97-107.
    8. Ubukata, Masato, 2018. "Dynamic hedging performance and downside risk: Evidence from Nikkei index futures," International Review of Economics & Finance, Elsevier, vol. 58(C), pages 270-281.
    9. Hamed Ghoddusi & Franz Wirl, 2019. "A Risk-Hedging View to Refinery Capacity Investment," Working Papers 1327, Economic Research Forum, revised 21 Aug 2019.
    10. Shrestha, Keshab & Subramaniam, Ravichandran & Peranginangin, Yessy & Philip, Sheena Sara Suresh, 2018. "Quantile hedge ratio for energy markets," Energy Economics, Elsevier, vol. 71(C), pages 253-272.
    11. Beatriz Martínez & Hipòlit Torró, 2016. "Anatomy of Risk Premium in UK Natural Gas Futures," Working Papers 2016.06, Fondazione Eni Enrico Mattei.
    12. Kunlapath Sukcharoen & Hankyeung Choi & David J. Leatham, 2015. "Optimal gasoline hedging strategies using futures contracts and exchange-traded funds," Applied Economics, Taylor & Francis Journals, vol. 47(32), pages 3482-3498, July.
    13. Shrestha, Keshab & Subramaniam, Ravichandran & Rassiah, Puspavathy, 2017. "Pure martingale and joint normality tests for energy futures contracts," Energy Economics, Elsevier, vol. 63(C), pages 174-184.
    14. Roncoroni, Andrea & Id Brik, Rachid, 2017. "Hedging size risk: Theory and application to the US gas market," Energy Economics, Elsevier, vol. 64(C), pages 415-437.
    15. Liu, Pan & Vedenov, Dmitry & Power, Gabriel J., 2017. "Is hedging the crack spread no longer all it's cracked up to be?," Energy Economics, Elsevier, vol. 63(C), pages 31-40.
    16. Olson, Eric & Vivian, Andrew & Wohar, Mark E., 2019. "What is a better cross-hedge for energy: Equities or other commodities?," Global Finance Journal, Elsevier, vol. 42(C).
    17. Cui, Yan & Feng, Yun, 2020. "Composite hedge and utility maximization for optimal futures hedging," International Review of Economics & Finance, Elsevier, vol. 68(C), pages 15-32.
    18. Martínez, Beatriz & Torró, Hipòlit, 2018. "Analysis of risk premium in UK natural gas futures," International Review of Economics & Finance, Elsevier, vol. 58(C), pages 621-636.
    19. Spencer, Simon & Bredin, Don & Conlon, Thomas, 2018. "Energy and agricultural commodities revealed through hedging characteristics: Evidence from developing and mature markets," Journal of Commodity Markets, Elsevier, vol. 9(C), pages 1-20.
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    21. Chai, Shanglei & Zhou, P., 2018. "The Minimum-CVaR strategy with semi-parametric estimation in carbon market hedging problems," Energy Economics, Elsevier, vol. 76(C), pages 64-75.

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    More about this item

    Keywords

    Hedging; Crack spread; GARCH; Minimum-variance hedge;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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