Asymmetric Effect of Basis on Dynamic Futures Hedging: Empirical Evidence from Commodity Markets

27 Pages Posted: 18 Feb 2007

See all articles by Donald D. Lien

Donald D. Lien

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

Li Yang

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Date Written: 2007

Abstract

Dynamic minimum variance hedge ratios (MVHRs) have been commonly estimated using Bivariate GARCH model that overlooks basis effect on the time-varying variance-covariance of spot and futures returns. This paper proposes an alternative specification of the BGARCH model in which the basis effect is incorporated for estimating MVHRs. Empirical investigation in commodity markets suggests that basis effect is asymmetric, i.e., positive basis has greater impact than negative basis on the variance and covariance structure. Both in-sample and out-of-sample comparisons of the MVHR performance reveal that the model with the asymmetric effect provides greater risk reduction than the conventional models, illustrating importance of the asymmetric effect when modeling joint dynamics of spot and futures returns and hence estimating hedging strategies.

Keywords: Dynamic hedging strategy, Asymmetric basis effect, Time-varying volatility and correlation of spot and futures returns

JEL Classification: G13, C32

Suggested Citation

Lien, Donald and Yang, Li, Asymmetric Effect of Basis on Dynamic Futures Hedging: Empirical Evidence from Commodity Markets (2007). Available at SSRN: https://ssrn.com/abstract=963250 or http://dx.doi.org/10.2139/ssrn.963250

Donald Lien

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)

Li Yang (Contact Author)

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+610293855857 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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