The Use and Abuse of the Hedging Effectiveness Measure

Posted: 23 Dec 2004

See all articles by Donald D. Lien

Donald D. Lien

University of Texas at San Antonio - College of Business - Department of Economics

Abstract

Edering (1979) proposed an effectiveness measure for futures hedging. Since then, this measure has been widely adopted in the literature to compare different hedge ratios against the OLS (ordinary least squares) hedge ratio. This note attempts to demonstrate this application is inappropriate. Ederington hedging effectiveness is only useful for measuring the risk reduction effect of the OLS hedge ratio. It does not apply to other hedge ratios and therefore should not serve as a criterion to compare different hedge strategies against the OLS strategy. A strict application of this measure almost always leads to an incorrect conclusion stating that the OLS hedge ratio is the best hedging strategy.

Keywords: Hedging effectiveness, OLS hedge ratio, unconditional variance, conditional variance

JEL Classification: G11

Suggested Citation

Lien, Donald, The Use and Abuse of the Hedging Effectiveness Measure. International Review of Financial Analysis, Forthcoming. Available at SSRN: https://ssrn.com/abstract=632804

Donald Lien (Contact Author)

University of Texas at San Antonio - College of Business - Department of Economics ( email )

6900 North Loop 1604 West
San Antonio, TX 78249
United States
210-458-4313 (Phone)
210-458-4308 (Fax)

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