The Optimal Hedging Ratio for Non-Ferrous Metals

The increased volatility that characterized the markets during the last years emphasized the need for hedging. Given their industrial usage, the non-ferrous metals have a great importance for the economic activity. The volatility and unpredictability of metals prices create risks for an important number of companies and for the economy. The existence of basis risk leads to the need for the optimal hedge ratio estimation. Our paper estimates the optimal hedging ratio in the case of the non-ferrous metals traded on the London Metals Exchange using three methods: the ordinary least squares regression, the error-correction model, and the auto regressive distributed lag model. It also provides an in-sample and an out-of-sample comparison between these three models. The results show that the optimal hedge ratio and hedging effectiveness increase with the hedging horizon, converging to 1 for long tenors. Our findings also show that the more complex models provide a greater in-sample hedging effectiveness, but for the out-of-sample analysis the increase in performance is not significant.