Cross Hedging Under Multiplicative Basis Risk

31 Pages Posted: 31 Mar 2011

See all articles by Axel F. A. Adam-Muller

Axel F. A. Adam-Muller

University of Trier, Fachbereich IV - BWL

Ingmar Nolte

Lancaster University - Department of Accounting and Finance

Date Written: February 3, 2011

Abstract

Cross hedging price risk in an incomplete financial market creates basis risk. We propose a new way of modeling basis risk where price risk and basis risk are combined in a multiplicative way. Under this specification, positive prudence is a necessary and sufficient condition for underhedging in an unbiased market. Using the example of cross hedging jet fuel price risk with crude oil futures, we show that the new specification is superior in describing the price series and that optimal cross hedges differ significantly from those derived under the traditional additive cross hedging model.

Keywords: risk management, cross hedging, basis risk, prudence, jet fuel, crude oil futures, vector error correction model

JEL Classification: D81, G11, G32

Suggested Citation

Adam-Muller, Axel F. A. and Nolte, Ingmar, Cross Hedging Under Multiplicative Basis Risk (February 3, 2011). Available at SSRN: https://ssrn.com/abstract=1799402 or http://dx.doi.org/10.2139/ssrn.1799402

Axel F. A. Adam-Muller (Contact Author)

University of Trier, Fachbereich IV - BWL ( email )

Trier, D-54296
Germany
+49-651-2012725 (Phone)
+49-651-201-3841 (Fax)

HOME PAGE: http://finance.uni-trier,de

Ingmar Nolte

Lancaster University - Department of Accounting and Finance ( email )

Lancaster, Lancashire LA1 4YX
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
182
Abstract Views
1,071
rank
166,979
PlumX Metrics