Optimal Hedging with Higher Moments

Cass Business School Research Paper

Journal of Futures Markets, 2012, 32 (10), 909-944

40 Pages Posted: 20 Mar 2008 Last revised: 30 Sep 2019

See all articles by Chris Brooks

Chris Brooks

University of Reading - ICMA Centre

Aleš Černý

Cass Business School, City, University of London

Joëlle Miffre

Audencia Nantes School of Management; Audencia Business School

Date Written: November 1, 2007

Abstract

This study proposes a utility-based framework for the determination of optimal hedge ratios that can allow for the impact of higher moments on hedging decision. We examine the entire hyperbolic absolute risk aversion (HARA) family of utilities which include quadratic, logarithmic, power and exponential utility functions. We find that for both moderate and large spot (commodity) exposures, the performance of out-of-sample hedges constructed allowing for non-zero higher moments is better than the performance of the simpler OLS hedge ratio. The picture however is not uniform throughout our seven spot commodities as there is one instance (cotton) for which the modeling of higher moments decreases welfare out-of-sample relative to the simpler OLS. We support our empirical findings by theoretical analysis of optimal hedging decisions and we uncover a novel link between optimal hedge ratios and the minimax hedge ratio, that is the ratio which minimizes the largest loss of the hedged position.

Keywords: utility-based hedging, OLS, non-normality risk, commodity futures, skewness, kurtosis

JEL Classification: G13, C53

Suggested Citation

Brooks, Chris and Černý, Aleš and Miffre, Joelle, Optimal Hedging with Higher Moments (November 1, 2007). Journal of Futures Markets, 2012, 32 (10), 909-944. Available at SSRN: https://ssrn.com/abstract=945807 or http://dx.doi.org/10.2139/ssrn.945807

Chris Brooks

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 118 931 82 39 (Phone)
+44 118 931 47 41 (Fax)

Aleš Černý (Contact Author)

Cass Business School, City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Joelle Miffre

Audencia Nantes School of Management ( email )

8 route de la Jonelière, BP 31222
Nantes Cedex 3, Cedex 3 44312
France

Audencia Business School ( email )

8 Road Joneliere
BP 31222
Nantes Cedex 3, 44312
France

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