A Square-Root T Hedging Rule for Nonstorable Products
6 Pages Posted: 3 May 2013
Date Written: April 29, 2013
This note derives a hedging rule under the assumption of noisy forward prices. Forward prices are assumed to be noisy due to non-storability of the underlying product and the resulting lack of carry arbitrage. The minimum-variance hedge ratio increases nonlinearly with decreasing time to maturity of the forward contract, as more information about the expected spot price arrives and the forward price becomes less noisy. If the noise component follows a process similar to a random walk, the precision of the forward price increases as a square-root function of the remaining trading time. By setting the initial hedge ratio according to hypothetically efficient prices, a producer overhedges and the minimum-variance hedge is not achieved.
Keywords: hedging, market efficiency, measurement error
JEL Classification: C13, C51, G13, G14
Suggested Citation: Suggested Citation