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Optimal Hedging with Higher Moments

  • Chris Brooks

    ()

    (ICMA Centre, University of Reading)

  • A.Cerny

    ()

    (Cass Business School)

  • J. Miffre

    ()

    (Cass Business School)

This study proposes a utility-based framework for the determination of optimal hedge ratios that can allow for the impact of higher moments on the hedging decision. The approach is applied to a set of 20 commodities that are hedged with futures contracts. We find that in sample, the performance of hedges constructed allowing for non-zero higher moments is only very slightly better than the performance of the much simpler OLS hedge ratio. When implemented out of sample, utility-based hedge ratios are usually less stable over time, and can make investors worse off for some assets compared to hedging using the traditional methods. We conclude, in common with a growing body of very recent literature, by suggesting that higher moments matter in theory but not in practice.

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File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2006-12.pdf
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Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2006-12.

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Length: 33 pages
Date of creation: Nov 2006
Date of revision:
Handle: RePEc:rdg:icmadp:icma-dp2006-12
Contact details of provider: Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA
Phone: +44 (0) 118 378 8226
Fax: +44 (0) 118 975 0236
Web page: http://www.henley.reading.ac.uk/
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  1. Y. Peter Chung & Michael J. Schill, 2006. "Asset Pricing When Returns Are Nonnormal: Fama-French Factors versus Higher-Order Systematic Comoments," The Journal of Business, University of Chicago Press, vol. 79(2), pages 923-940, March.
  2. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
  3. Christie-David, Rohan & Chaudhry, Mukesh, 2001. "Coskewness and cokurtosis in futures markets," Journal of Empirical Finance, Elsevier, vol. 8(1), pages 55-81, March.
  4. Chris Brooks & Olan T. Henry & Gita Persand, 2002. "The Effect of Asymmetries on Optimal Hedge Ratios," The Journal of Business, University of Chicago Press, vol. 75(2), pages 333-352, April.
  5. Chunhachinda, Pornchai & Dandapani, Krishnan & Hamid, Shahid & Prakash, Arun J., 1997. "Portfolio selection and skewness: Evidence from international stock markets," Journal of Banking & Finance, Elsevier, vol. 21(2), pages 143-167, February.
  6. Ederington, Louis H, 1979. "The Hedging Performance of the New Futures Markets," Journal of Finance, American Finance Association, vol. 34(1), pages 157-70, March.
  7. Giovanni Barone Adesi & Patrick Gagliardini & Giovanni Urga, 2004. "Testing Asset Pricing Models With Coskewness," Journal of Business & Economic Statistics, American Statistical Association, vol. 22, pages 474-485, October.
  8. Chris Brooks & Harry. M Kat, 2001. "The Statistical Properties of Hedge Fund Index Returns," ICMA Centre Discussion Papers in Finance icma-dp2001-09, Henley Business School, Reading University.
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