Carry Costs and Futures Hedge Calculations
Advances in Investment Analysis and Portfolio Management, Vol. 6, pp. 1-34, 2014
34 Pages Posted: 25 Nov 2015
Date Written: March 31, 2014
This paper calculates carry costs directly and focuses on the effect that carry cost lumpiness has on hedge variables. It shows that carry cost adjusted price changes should be used to reduce errors in the calculated hedge: ratio, profit, and effectiveness. Results demonstrate that the errors can be both statistically and economically significant and tend to be more significant if the asset’s carry costs are lumpier (that is, larger and less frequent). We study the traditional regression (TR), carry cost adjusted regression (CCAR), and error correction (EC) hedge ratio calculation approaches. Unlike the CCAR method, the TR and EC approaches err by using the spot price change to represent spot profit. When the payout dates are included in the analysis, the CCAR in-sample hedge effectiveness is statistically significantly higher than it is for the TR and EC approaches. Furthermore, when payout dates are excluded, their hedge effectiveness results converge toward those for the CCAR method. The CCAR approach provides out-of-sample hedge effectiveness that is higher than that for either of the other approaches. Additionally, the (in-sample to out-of-sample) hedge effectiveness slippage is about half as much for the TR and CCAR approaches as it is for the EC approach. Finally, though the hedge ratios are similar across methods, the hedge profits of the assets studied are significantly mismeasured because the TR and EC methods ignore carry costs.
Keywords: Futures Hedge Ratio, Hedge Profits, Hedge Effectiveness
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