Incentive mechanisms and hedging effectiveness – an experimental study

Purpose - The purpose of this paper is to analyze the role of four different incentives in improving hedging effectiveness and propose an alternative regulatory mechanism for China’s futures market. Design/methodology/approach - The research method that this study uses is a laboratory experiment, and this study follows the basic norms of experimental research. In addition, this paper designs and conducts a game experiment between hedgers and futures brokerage firms (FBFs) under different incentive mechanisms. Findings - By analyzing the experimental data, it is found that compared with other incentive mechanisms, hedgers’ willingness to hedge and FBFs’ regulatory intention are both significantly higher for the dynamic linkage updating mechanism, indicating that hedgers have a stronger willingness to follow their hedging plan, and FBFs are more responsible for their regulatory behaviors. Additionally, the dynamic linkage updating mechanism has a long-term impact on effective hedging in the futures market. Research limitations/implications - The findings suggest that the dynamic linkage updating mechanism is beneficial for effectively restricting both hedgers’ over-speculation and FBFs’ regulatory slack and improving the hedging efficiency of the futures market. Practical implications - To solve the problem of inefficient hedging in China’s futures market, i.e., hedgers’ over-speculation and FBFs’ passive collusion with hedgers, the regulators of China’s futures market should reform the existing incentives and adopt a dynamic linkage updating mechanism to encourage all the participants to actively improve hedging effectiveness. Originality/value - This paper analyzes and verifies, for the first time, the role of the dynamic linkage updating mechanism in the investing behaviors of hedgers and the regulatory behaviors of future brokerage firms. The futures market experiment that was designed and used in this study is a pioneering and exploratory experiment that applies game theory and mechanism design theory to the field of behavioral finance.