Will Tighter Futures Price Limits Decrease Hedge Effectiveness?
46 Pages Posted: 23 Aug 2010
Date Written: August 23, 2010
The recent events triggered by the Global Financial Crisis (GFC) have led to calls for regulation of financial (particularly derivative) markets to prevent “destabilizing speculation”. Given that such regulation may involve opportunity costs, this paper examines whether tighter futures price limits can reduce the effectiveness of a futures hedge. A new model is proposed that uncovers the underlying joint spot-futures dynamics when futures prices are subject to limits. The model is then used to determine the maximum number of limit days before minimum variance hedging outcomes are adversely affected. An application to US soybeans and corn reveals that existing price limits have not reduced hedge effectiveness. If the frequency of limit days increases from current levels of around 1% to approximately 3% to 4% however, conventional hedging approaches will experience economically and statistically significant increases in portfolio variance. These results are of importance for hedgers, clearing houses and regulators in light of the recent calls for derivatives regulation.
Keywords: Price Limits, Long Memory, Maturity Effects, Tobit
JEL Classification: GO, C32, C34
Suggested Citation: Suggested Citation