The (De)merits of Minimum-Variance Hedging: Application to the Crack Spread

26 Pages Posted: 16 Jan 2012 Last revised: 29 Dec 2013

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Peking University HSBC Business School

Marcel Prokopczuk

Leibniz Universit├Ąt Hannover - Faculty of Economics and Management; University of Reading - ICMA Centre

Anannit Sumawong

University of Sussex

Date Written: November 12, 2012

Abstract

We study the empirical performance of the classical minimum-variance hedging strategy, comparing several econometric models for estimating hedge ratios of crude oil, gasoline and heating oil crack spreads. Given the great variability and large jumps in both spot and futures prices, great care is required when processing the relevant data and accounting for the costs of maintaining and re-balancing the hedge position. We find that the variance reduction produced by all models are statistically and economically indistinguishable from the one-for-one naive hedge. However, minimum-variance hedging models, especially those based on GARCH, generate much greater margin and transaction costs than the naive hedge. Therefore we encourage hedgers to use a naive hedging strategy on the crack spread bundles now offered by the exchange as it is the cheapest and easiest to implement. Our conclusion contradicts the majority of the existing literature, which favours the implementation of GARCH-based hedging strategies.

Keywords: Hedging, Crack Spread, GARCH, Minimum-Variance Hedge

JEL Classification: G10, C52, G32

Suggested Citation

Alexander, Carol and Prokopczuk, Marcel and Sumawong, Anannit, The (De)merits of Minimum-Variance Hedging: Application to the Crack Spread (November 12, 2012). Energy Economics, Vol. 36, No. 1, 2013, Available at SSRN: https://ssrn.com/abstract=1986047 or http://dx.doi.org/10.2139/ssrn.1986047

Carol Alexander

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.carolalexander.org

Peking University HSBC Business School ( email )

Marcel Prokopczuk

Leibniz Universit├Ąt Hannover - Faculty of Economics and Management ( email )

Koenigsworther Platz 1
Hannover, 30167
Germany

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

Anannit Sumawong (Contact Author)

University of Sussex ( email )

Sussex House
Falmer
Brighton, Sussex BNI 9RH
United Kingdom

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