A Square-Root T Hedging Rule for Nonstorable Products

6 Pages Posted: 3 May 2013

Date Written: April 29, 2013

Abstract

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

Sihvonen, Jukka, A Square-Root T Hedging Rule for Nonstorable Products (April 29, 2013). Available at SSRN: https://ssrn.com/abstract=2259611 or http://dx.doi.org/10.2139/ssrn.2259611

Jukka Sihvonen (Contact Author)

Aalto University ( email )

P.O. Box 21210
Helsinki, 00101
Finland

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