Risk Minimizing Hedging of Crude-Oil Options: Theory and Empirical Performance
University of Glasgow; Center for Dynamic Macroeconomic Analysis, University of St. Andrews - School of Economics and Finance
University of Sydney
Macquarie University, Faculty of Business and Economics
May 16, 2011
We study the hedging problem for European-style options written on crude-oil futures. Locally risk-minimizing hedging strategies are derived under the assumption that the dynamics of crude-oil futures are described by a Merton-type jump-diffusion. These are then tested empirically using historical data from the NYMEX West Texas Intermediate (WTI) from the 2002-2007 period. We use Black-Scholes-Merton delta hedges as a benchmark for comparison and find that in crude-oil option markets locally risk-minimizing hedges systematically outperform the benchmark by a margin of 13%-18%. In addition to this real world performance test, we also investigate hedging strategies for robustness against model uncertainty and mis-specification, using simulated data. Our results show that locally risk minimizing strategies are much more robust than its classical alternatives.
Number of Pages in PDF File: 35
Keywords: Risk-minimizing hedging, crude-oil options, futures, energy derivatives, resource economics
JEL Classification: Q40, G11, C44working papers series
Date posted: May 25, 2011 ; Last revised: July 27, 2011
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