The Use of Copulas in Hedging Oil and Market Price Risk for US Oil and Gas Investors: Empirical Investigation

Abstract

Using copulas, we investigate the pairwise dependence structures between two risk factors, oil price and aggregate market index price, and the US oil and gas sub-sector indices. We also explore the out-of-sample hedging performance of a hedging strategy by minimizing the conditional Value-at-Risk of the hedged portfolios composed with sub-sector index and futures contract after estimating the time-varying parameters of copulas. We compare the hedging effectiveness of this strategy with the hedging strategy for minimizing the volatility of hedged portfolios using five hedging performance measures.

Our results suggest that Integrated oil & gas and Pipelines sub-sectors have lower tail depen- dence coefficients with oil price and market index price compared with the other two sub-sectors. However, the results of the out-of-sample investigation suggests that the hedging strategy with using copulas and conditional Value-at-Risk underperforms in risk reduction compared with the hedging strategy with Ordinary Least Squares and volatility.

Keywords: U.S. oil and gas; Copula; Risk management; Hedging; Portfolio; Performance evaluation

JEL Classification: C58; C61; G10; G11