Hedging with Two Futures Contracts: Simplicity Pays

42 Pages Posted: 15 Apr 2010

See all articles by Van Thi Tuong Nguyen

Van Thi Tuong Nguyen

KU Leuven

Katelijne A. E. Carbonez

KU Leuven - Faculty of Business and Economics (FEB)

Piet Sercu

FEB at KU Leuven

Date Written: March 2, 2010

Abstract

We propose to use two futures contracts in hedging an agricultural commodity commitment to solve either the standard delta hedge or the roll-over issue. Most current literature on dual-hedge strategies is based on a structured model to reduce roll-over risk and is somehow difficult to apply for agricultural futures contracts. Instead, we propose to apply a regression based model and a naive rules of thumb for dual-hedges which are applicable for agricultural commodities.

The naive dual strategy stems from the fact that in a large sample of agricultural commodities, De Ville, Dhaene and Sercu (2008) find that Garch-based hedges do not perform as well as ols-based ones and that we can avoid estimation error with such a simple rule. Our expectations-based naive hedge ratios are driven from two conditions: omitting exposure to spot price and eliminating the expected basis effects on the portfolio values. It is also noisy, though, so the first-pass hedge ratios need to be smoothed. (We use a modified version of Gelper et al. (2007) for the purpose.) We find that, generally, (i) rebalancing helps; (ii) the two-contract hedging rules do better than the one-contract counterparts, even for standard delta hedges without rolling-over; (iii) simplicity pays: within the two-contract group, the expectations-based naive rule systematically beats the others in most cases and Garch performs worse than ols for either one-contract or two contract hedges; and (v) smoothing procedure does help even for regression models. These conclusions are based on the tests on unconditional variance (Diebold and Mariano, 1995) and those on conditional risk (Giacomini and White (2006)).

Keywords: Hedging Strategy, Hedge Ratio, Convenience Yield

JEL Classification: G11, Q11, Q14

Suggested Citation

Nguyen, Van Thi Tuong and Carbonez, Katelijne A. E. and Sercu, Piet M. F. A., Hedging with Two Futures Contracts: Simplicity Pays (March 2, 2010). Available at SSRN: https://ssrn.com/abstract=1588583 or http://dx.doi.org/10.2139/ssrn.1588583

Van Thi Tuong Nguyen (Contact Author)

KU Leuven ( email )

Oude Markt 13
Leuven, Vlaams-Brabant 3000
Belgium
0032 16 32 64 62 (Phone)

Katelijne A. E. Carbonez

KU Leuven - Faculty of Business and Economics (FEB) ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

Piet M. F. A. Sercu

FEB at KU Leuven ( email )

Naamsestraat 69
Faculty of Economics and Business
Leuven, 3000
Belgium
+32 16 32 67 56 (Phone)
+32 16 32 67 32 (Fax)

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