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Downside risk and the energy hedger's horizon

  • Thomas Conlon

    (Smurfit School of Business, University College Dublin)

  • John Cotter

    (UCD Smurfit School of Business, University College Dublin)

In this paper, we explore the impact of investor time-horizon on an optimal downside hedged energy portfolio. Previous studies have shown that minimum-variance hedging effectiveness improves for longer horizons using variance as the performance metric. This paper investigates whether this result holds for different hedging objectives and effectiveness measures. A wavelet transform is applied to calculate the optimal heating oil hedge ratio using a variety of downside objective functions at different time-horizons. We demonstrate decreased hedging effectiveness for increased levels of uncertainty at higher confidence intervals. Moreover, for each of the different hedging objectives and effectiveness measures studied, we also demonstrate increasing hedging effectiveness at longer horizons. While small differences in effectiveness are found across the different hedging objectives, time-horizon effects are found to dominate confirming the importance of considering the hedgers horizon. The findings suggest that while downside risk measures are useful in the computation of an optimal hedge ratio that accounts for unwanted negative returns, hedging horizon and confidence intervals should also be given careful consideration by the energy hedger.

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File URL: http://www.ucd.ie/geary/static/publications/workingpapers/gearywp201219.pdf
File Function: First version, 2012
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Paper provided by Geary Institute, University College Dublin in its series Working Papers with number 201219.

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Length: 28 pages
Date of creation: 17 Sep 2012
Date of revision:
Handle: RePEc:ucd:wpaper:201219
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  1. John Cotter & Jim Hanly, 2011. "A Utility Based Approach to Energy Hedging," Working Papers 201106, Geary Institute, University College Dublin.
  2. Thomas Conlon & John Cotter, 2012. "An empirical analysis of dynamic multiscale hedging using wavelet decomposition," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(3), pages 272-299, 03.
  3. Cotter, John & Hanly, Jim, 2010. "Time-varying risk aversion: An application to energy hedging," Energy Economics, Elsevier, vol. 32(2), pages 432-441, March.
  4. Gencay, Ramazan & Selcuk, Faruk & Whitcher, Brandon, 2005. "Multiscale systematic risk," Journal of International Money and Finance, Elsevier, vol. 24(1), pages 55-70, February.
  5. Bertsimas, Dimitris & Lauprete, Geoffrey J. & Samarov, Alexander, 2004. "Shortfall as a risk measure: properties, optimization and applications," Journal of Economic Dynamics and Control, Elsevier, vol. 28(7), pages 1353-1381, April.
  6. Rua, António & Nunes, Luís C., 2009. "International comovement of stock market returns: A wavelet analysis," Journal of Empirical Finance, Elsevier, vol. 16(4), pages 632-639, September.
  7. Kuang-Liang Chang, 2011. "The optimal value-at-risk hedging strategy under bivariate regime switching ARCH framework," Applied Economics, Taylor & Francis Journals, vol. 43(21), pages 2627-2640.
  8. 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.
  9. Ming-Chih Lee & Jui-Cheng Hung, 2007. "Hedging for multi-period downside risk in the presence of jump dynamics and conditional heteroskedasticity," Applied Economics, Taylor & Francis Journals, vol. 39(18), pages 2403-2412.
  10. Francis In & Sangbae Kim, 2006. "The Hedge Ratio and the Empirical Relationship between the Stock and Futures Markets: A New Approach Using Wavelet Analysis," The Journal of Business, University of Chicago Press, vol. 79(2), pages 799-820, March.
  11. 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.
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  13. Naccache, Théo, 2011. "Oil price cycles and wavelets," Energy Economics, Elsevier, vol. 33(2), pages 338-352, March.
  14. Adam, Alexandre & Houkari, Mohamed & Laurent, Jean-Paul, 2008. "Spectral risk measures and portfolio selection," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1870-1882, September.
  15. Turvey, Calum G. & Nayak, Govindaray, 2003. "The Semivariance-Minimizing Hedge Ratio," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 28(01), April.
  16. Sadorsky, Perry, 2000. "The empirical relationship between energy futures prices and exchange rates," Energy Economics, Elsevier, vol. 22(2), pages 253-266, April.
  17. René M. Stulz, 1996. "Rethinking Risk Management," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(3), pages 8-25.
  18. Babak Eftekhari, 1998. "Lower partial moment hedge ratios," Applied Financial Economics, Taylor & Francis Journals, vol. 8(6), pages 645-652.
  19. Louis Ederington & Jae Ha Lee, 2002. "Who Trades Futures and How: Evidence from the Heating Oil Futures Market," The Journal of Business, University of Chicago Press, vol. 75(2), pages 353-374, April.
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