Minimum Variance Hedging when Spot Price Changes are Partially Predictable

Abstract:     
In many markets, changes in the spot price are partially predictable. We show that when this is the case: 1) although unbiased, traditional regression estimates of the minimum variance hedge ratio are inefficient, 2) estimates of the riskiness of both hedged and unhedged positions are biased upward, and 3) estimates of the percentage risk reduction achievable through hedging are biased downward. For natural gas cross hedges, we find that both the inefficiency and bias are substantial. We further find that incorporating the expected change in the spot price, as measured by the futures-spot spread, into the regression results in a substantial increase in efficiency and reduction in the bias. Accounting for seasonal price patterns results in a smaller efficiency improvement and bias reduction.

Number of Pages in PDF File: 41

Keywords: hedging, natural gas markets

JEL Classification: G13

working papers series