will tighter futures price limits decrease hedge effectiveness abstract the events triggered by the global financial crisis gfc have led to calls for the regulation of financial markets given that regulation may involve opportunity costs this paper examines whether tighter futures price limits can reduce the effectiveness of a futures hedge we propose a new model that uncovers the underlying spot futures dynamics when futures prices are subject to limits we use the model to determine the maximum number of limit days that can occur before minimum variance hedging outcomes are adversely affected application of this model to the us soybean and corn markets reveals that existing limits do not reduce hedge effectiveness if the frequency of limit days increases from current levels of 1 to approximately 3 4 conventional hedging approaches will experience economically and statistically significant increases in portfolio variance these results are important for hedgers clearing houses and regulators in light of the recent calls for derivatives regulation

answering the skeptics yes standard volatility models do provide accurate forecasts a voluminous literature has emerged for modeling the temporal dependencies in financial market volatility using arch and stochastic volatility models while most of these studies have documented highly significant in sample parameter estimates and pronounced intertemporal volatility persistence traditional ex post forecast evaluation criteria suggest that the models provide seemingly poor volatility forecasts contrary to this contention we show that volatility models produce strikingly accurate interdaily forecasts for the latent volatility factor that would be of interest in most financial applications new methods for improved ex post interdaily volatility measurements based on high frequency intradaily data are also discussed

price movements and price discovery in futures and cash markets r isk transfer and price discovery are two of the major contributions of futures markets to the organization of economic activity working 1962 evans 1978 p 80 and silber 1981 risk transfer refers to hedgers using futures contracts to shift price risk to others price discovery refers to the use of futures prices for pricing cash market transactions working 1948 wiese 1978 p 87 and lake 1978 p 161 the significance of both contributions depends upon a close relationship between the prices of futures contracts and cash commodities this paper examines the characteristics of price movements in cash or spot markets and futures markets for storable commodities section ii presents an analytical model of simultaneous price dynamics which suggests that over short intervals of time the correlation of price changes is a function of the elasticity of arbitrage between the physical commodity and its counterpart futures contract greater elasticity fosters more highly correlated price changes and thereby facilitates the risk transfer function the elasticity of supply of arbitrage services is constrained by among other things storage and transaction costs thus futures contracts will not in general provide perfect risk transfer facilities over short time horizons the essence of the price discovery function of futures markets hinges on whether new information is reflected first in changed futures prices or in changed cash prices hoffman 1932 pp 258259 the model in section ii provides a framework for analyzing whether one market is dominant in terms of information flows and price discovery in section iii we develop a model based on section ii which is appropriate for estimating the lead lag relationship between cash prices and futures prices section iv presents empirical estimates of the parameters of the model for seven different storable commodities wheat corn oats frozen orange juice concentrates copper gold and silver the cost of arbitrage between cash and futures differs across these commodities for this reason we are not surprised to find inter commodity differences in the correlation of short run price changes and in the substitutability of futures contracts for cash market positions with respect to the price discovery function of futures markets we find that while futures markets dominate cash markets cash prices do not merely echo futures prices there are reverse information flows from cash markets to futures markets as well

the time pattern of hedging and the volatility of futures prices the paper proposes a multi period model of hedging which allows for a futures position to be revised within the cash market holding period within this framework we assess the robustness of the two period theory of hedging when generalized to many periods we characterize the normal time path of a hedge and the way it is affected by the requirement that futures accounts mark to market daily finally we show how the resolution of production uncertainty over time affects hedging behavior and determines the volatility of futures prices in the large literature on hedging in futures markets the principal analytical accounts of hedging are framed in a two trade date setting an agent commits himself now to a future purchase or sale of a good whose cash price later is uncertain this risk is hedged by purchase or sale of an appropriate number of futures contracts and holding this futures position until the cash transaction is realized in the present paper we formulate a multi period model of hedging which allows for the futures position to be revised within the cash market holding period the resulting analysis captures an important institutional reality that is absent in a two trade date model namely the fact that the day to day fluctuations of the futures price will generate a series of random cash flows over the period during which a futures position is held this is due to the requirement that futures accounts mark to market daily within this framework we address a number of issues first we assess the robustness of the two period theory of hedging when generalized to many periods second we characterize the normal time path of a hedge and contrast futures and forward contracts from the perspective of an individual hedger finally we show how the resolution of production uncertainty over time affects hedging behaviour and determines the volatility of futures prices while the literature on asset demand in a multiperiod setting is large futures markets are specifically treated in a limited number of studies grauer and litzenberger 1976 are concerned principally with characterizing the relation of spot and futures prices in a market for a storable periodically produced commodity they offer a rationale for positive stock holding in markets where spot price exceeds the futures price richard and sundaresan 1980 are also concerned primarily with characterizing price behaviour since they posit identical consumers in equilibrium individual holdings of futures are zero there is no hedging activity in the sense that we understand it breeden 1980b analyzes the optimal futures position sizes in a multiperiod setting his framework is more general than ours in that his is a multi good multi asset model where preferences

optimal hedging and spreading in cointegrated markets abstract assuming that cash and futures markets are cointegrated this article derives the optimal multiperiod hedging strategy the model is then extended to the case of two futures markets optimal intramarket or intermarket spreading strategy is provided therein

bivariate garch estimation of the optimal commodity futures hedge six different commodities are examined using daily data over two futures contract periods cash and futures prices for all six commodities are found to be well described as martingales with near integrated garch innovations bivariate garch models of cash and futures prices are estimated for the same six commodities the optimal hedge ratio ohr is then calculated as a ratio of the conditional covariance between cash and futures to the conditional variance of futures the estimated ohrs reveal that the standard assumption of a time invariant ohr is inappropriate for each commodity the estimated ohr path appears non stationary which has important implications for hedging strategies

implied volatility functions empirical tests derman and kani 1994 dupire 1994 and rubinstein 1994 hypothesize that asset return volatility is a deterministic function of asset price and time and develop a deterministic volatility function dvf option valuation model that has the potential of fitting the observed cross section of option prices exactly using s p 500 options from june 1988 through december 1993 we examine the predictive and hedging performance of the dvf option valuation model and find it is no better than an ad hoc procedure that merely smooths black scholes 1973 implied volatilities across exercise prices and times to expiration

maximum likelihood estimation of fractional cointegration with an application to u s and canadian bond rates we estimate a multivariate arfima model to illustrate a cointegration testing methodology based on joint estimates of the fractional orders of integration of a cointegrating vector and its parent series previous cointegration tests relied on a two step testing procedure and maintained the assumption in the second step that the parent series were known to have a unit root in our empirical example of fractional cointegration we illustrate how uncertainty regarding the order of integration of the parent series can be even more important than uncertainty regarding the order of integration of the cointegrating vector when testing for cointegration

failure of blackwell s theorem under machina s generalization of expected utility analysis without the independence axiom abstract considerable evidence suggests that the independence axiom of expected utility theory is not empirically supported in response machina has generalized expected utility theory in such a way that the independence axiom is not required most of the basic concepts and results of expected utility theory still hold under machina s generalization however blackwell s theorem a fundamental result in information economics fails to hold under machina s generalization of expected utility theory without the independence axiom

the linkages persistence asymmetry in the volatility the price discovery and efficiency and the effect of the us subprime mortgage financial crisis on the spot and the futures market s returns the case of india abstractthis article examines the effects of persistence asymmetry and the us subprime mortgage crisis on the volatility of the returns and also the price discovery efficiency and the linkages and causality between the spot and futures volatility by using various classes of the arch and garch models and through the granger s causality we have used two indices one for spot and the other for futures for the daily data from 12 june 2000 to 30 september 2013 from nifty stock indices we have then tested for arch effects and subsequently employed various models of the arch and garch conditional volatility the garch 1 1 model is found to be significant and it implies that the returns are not autocorrelated and have short memory it supports the hypothesis of the efficiency of the markets the negative news has more significant effect on volatility corroborating the leverage impact in finance on market volatility we have also tested the volatility spillover effects the two methods we employed

preference free optimal hedging using futures abstract this paper provides an alternative formulation and proof of the conditions under which optimal hedge ratios are independent of risk preference and points out that the conditions are satisfied by a wide class of models of spot and futures returns

an analysis on the short term sectoral competitiveness impact of carbon tax in china abstract market based instruments particularly carbon tax have recently drawn the attention of chinese government by their cost effective contribution to the achievement of china s climate targets most of the recent policy proposals have focused on its long term impact however particularly for policy makers both long term and short term effects of carbon tax would be necessary when determining tax rates we provided a detailed analysis of short term impacts of carbon tax on sectoral competitiveness in this paper we divided china s economy into 36 sectors based on its 2007 input output table in order to examine the ratio of carbon tax added costs to sector gdp we were thus able to determine the impact level of a carbon tax on each sector we then divided the sectoral trade impact into domestic competitiveness with regards to foreign imported products and international competitiveness external to the chinese domestic market we found that a high tax level 100 yuan t co2 may necessitate compensatory measures to certain highly affected industries and that a low tax rate 10 yuan t co2 would generate few competitiveness problems for all industries and may therefore be considered as an appropriate starting point

optimal dynamic hedging in unbiased futures markets a discrete time dynamic hedging problem is solved under expected utility maximization and basis risk without imposing a particular parametric form for utility nor assuming normally distributed cash and futures prices the solution is valid for any increasing and strictly concave utility function and for quite general specifications of the joint distribution of cash and futures prices this generality is achieved by restricting the futures market to be unbiased and requiring that the size of the cash position be nonstochastic the dynamic hedging rule can be estimated empirically using similar methods to those used to estimate static hedge ratios

cross hedging under multiplicative basis risk cross hedging price risk in an incomplete financial market creates basis risk we propose a new way of modeling basis risk where price risk and basis risk are combined in a multiplicative way under this specification positive prudence is a necessary and sufficient condition for underhedging in an unbiased market using the example of cross hedging jet fuel price risk with crude oil futures we show that the new specification is superior in describing the price series and that optimal cross hedges differ significantly from those derived under the traditional additive cross hedging model

on the pitfalls of multi year rollover hedges the case of hedge to arrive contracts it is shown that it is theoretically infeasible for multi year rollover hedge to arrive contracts and for rollover hedges in general to succeed at locking in high current prices for crops to be harvested one or more years into the future the study utilizes 107 years of data to present strong empirical evidence that the corn market behaves remarkably similarly to what price theory predicts results also confirm that short historical time series are unreliable for predicting rare events hence empirical studies of risk management contracts capitalizing on unusual occurrences should use samples sufficiently large to contain a meaningful number of relevant observations copyright 2001 oxford university press

provisional liquidation of futures hedge programs abstract frequently a firm sets a capital allowance for its risk management program such that early liquidation is dictated when the loss from the derivative position exceeds the allowance using a two period framework we show that the early liquidation decision is supported when futures returns exhibit positive first order autocorrelation an empirical study concerning natural gas acquisition of a local distribution company ldc demonstrates possibilities of early liquidation underlying optimal hedge policies

hedging for multi period downside risk in the presence of jump dynamics and conditional heteroskedasticity this study extends the one period zero var value at risk hedge ratio proposed by hung et al 2005 to the multi period case and incorporates the hedging horizon into the objective function under var framework the multi period zero var hedge ratio has several advantages first compared to existing hedge ratios based on downside risk it has an analytical solution and is simple to calculate second compared to the traditional minimum variance mv hedge ratio it considers expected return and remains optimal while the martingale process is invalid thirdly hedgers may elect an adequate hedging horizon and confidence level to reflect their level of risk aversion using the concept of var pondering the occurrence of volatility clustering and price jumps this study utilizes the arji model to compute time varying hedge ratios finally both in sample and out of sample hedging effectiveness between one period hedge ratio and multi period hedge ratio are evaluated for four hedging horizons and various le

european natural gas seasonal effects on futures hedging abstract this paper is the first to discuss the design of futures hedging strategies in european natural gas markets nbp ttf and zeebrugge a common feature of energy prices is that conditional mean and volatility are driven by seasonal trends due to weather demand and storage level seasonalities this paper follows and extends the ederington and salas 2008 framework and considers seasonalities in mean and volatility when minimum variance hedge ratios are computed our results show that hedging effectiveness is much higher when the seasonal pattern in spot price changes is approximated with lagged values of the basis futures price minus spot price this fact remains true for short a week and long one three and six months hedging periods furthermore volatility of weekly price changes also has a seasonal pattern and is higher in winter than in summer a simple volatility seasonal model that is based on sinusoidal functions on the basis improves the risk reduction obtained by strategies in which hedging ratios are estimated with linear regressions seasonal hedging strategies linear regression based strategies or even a naive position perform better than more sophisticated statistical methods

asymmetric effect of basis on dynamic futures hedging empirical evidence from commodity markets abstract the dynamic minimum variance hedge ratios mvhrs have been commonly estimated using the bivariate garch model that overlooks the 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 effect is incorporated for estimating mvhrs empirical investigation in commodity markets suggests that the basis effect is asymmetric i e the positive basis has greater impact than the 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 the joint dynamics of spot and futures returns and hence estimating hedging strategies

tails curtailed accounting for nonlinear dependence in pricing margin insurance for dairy farmers livestock gross margin insurance for dairy cattle lgm dairy is a risk management tool for protecting milk income over feed cost margins in this article we examine the assumptions underpinning the method used to determine lgm dairy premiums analysis of the milk feed dependence structure is conducted using copula methods a rich set of tools that allow modelers to capture nonlinearities in dependence among variables of interest we find a significant relationship between milk and feed prices that increases with time to maturity and severity of negative price shocks extremal or tail dependence is the propensity of dependence to concentrate in the tails of a distribution a common theme in financial and actuarial applications and in agricultural crop revenue insurance is that tail dependence increases the risk to the underwriter and results in higher insurance premiums we present to our knowledge the first case in which tail dependence may actually reduce actuarially fair premiums for an agricultural risk insurance product we examine hedging effectiveness with lgm dairy and show that even in the absence of basis or production risk hedging horizon plays an important role in the ability of this tool to smooth farm income over feed cost margins over time rating methodology that accounts for tail dependence between milk and feed prices extends the optimal hedging horizon and increases hedging effectiveness of the lgm dairy program

analyzing and forecasting volatility spillovers asymmetries and hedging in major oil markets crude oil price volatility has been analyzed extensively for organized spot forward and futures markets for well over a decade and is crucial for forecasting volatility and value at risk var there are four major benchmarks in the international oil market namely west texas intermediate usa brent north sea dubai oman middle east and tapis asia pacific which are likely to be highly correlated this paper analyses the volatility spillover and asymmetric effects across and within the four markets using three multivariate garch models namely the constant conditional correlation ccc vector arma garch varma garch and vector arma asymmetric garch varma agarch models a rolling window approach is used to forecast the 1 day ahead conditional correlations the paper presents evidence of volatility spillovers and asymmetric effects on the conditional variances for most pairs of series in addition the forecast conditional correlations between pairs of crude oil returns have both positive and negative trends moreover the optimal hedge ratios and optimal portfolio weights of crude oil across different assets and market portfolios are evaluated in order to provide important policy implications for risk management in crude oil markets

mean gini portfolio theory and the pricing of risky assets this paper presents the mean gini mg approach to analyze risky prospects and construct optimum portfolios the proposed method has the simplicity of a mean variance model and the main features of stochastic dominance efficiency since mean gini is consistent with investor behavior under uncertainty for a wide class of probability distributions gini s mean difference is shown to be more adequate than the variance for evaluating the variability of a prospect the mg approach is then applied to capital markets and the security valuation theorem is derived as a general relationship between average return and risk this is further extended to include a degree of risk aversion that can be estimated from capital market data the analysis is concluded with the concentration ratio to allow for the classification of different securities with respect to their relative riskiness

index arbitrage and nonlinear dynamics between the s p 500 futures and cash we use a cost of carry model with nonzero transaction costs to motivate estimation of a nonlinear dynamic relationship between the s p 500 futures and cash indexes discontinuous arbitrage suggests that a threshold error correction mechanism may characterize many aspects of the relationship between the futures and cash indexes we use minute by minute data on the s p 500 futures and cash indexes the results indicate that nonlinear dynamics are important and related to arbitrage and suggest that arbitrage is associated with more rapid convergence of the basis to the cost of carry than would be indicated by a linear model article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

a fractional cointegration analysis of purchasing power parity a generalized notion of cointegration called fractional cointegration is introduced to examine the long run purchasing power parity ppp hypothesis by allowing deviations from equilibrium to follow a fractionally integrated process the fractional cointegration analysis can capture a wider range of mean reversion behavior than standard cointegration analyses this gain is flexibility in modeling subtle mean reverting dynamics is found to be important for a proper evaluation of long run ppp empirical results based on historical data for the 1914 1989 period show that ppp reversion exists and can be characterized by a fractionally integrated process in three out of five countries studied the results support ppp as a long run phenomenon though significant short run deviations from ppp can exist

generalized optimal hedge ratio estimation a generalized approach to estimating optimal hedge ratios on futures markets is developed the generalized approach is not difficult to apply and provides a framework for evaluating the appropriateness of conventional simple regression approaches to optimal hedge ratio estimation in an application to storage hedging of corn soybeans and wheat it is found that simple regression using price levels or returns leads to errors in optimal hedge ratio estimation but that simple regression using price changes provides reasonably accurate estimates

rollover hedging and missing long term futures markets sequential rollover of annual futures positions provides farmers or others with a means of long term hedging consequently the absence of multiyear futures markets may not be a serious problem however year to year basis risk exists which can render rollovers ineffective in hedging evidence on soybean corn and cotton futures suggests that rollovers would be effective at locking in an initial price for a three to six year period but would be ineffective in routine hedging over a series of successive three to six year periods

some recent developments in futures hedging the use of futures contracts as a hedging instrument has been the focus of much research at the theoretical level an optimal hedge strategy is traditionally based on the expected utility maximization paradigm a simplification of this paradigm leads to the minimum variance criterion although this paradigm is quite well accepted alternative approaches have been sought at the empirical level research on futures hedging has benefited from the recent developments in the econometrics literature much research has been done on improving the estimation of the optimal hedge ratio as more is known about the statistical properties of financial time series more sophisticated estimation methods are proposed in this survey we review some recent developments in futures hedging we delineate the theoretical underpinning of various methods and discuss the econometric implementation of the methods

production hedging and speculative decisions with options and futures markets this paper analyzes production hedging and speculative decisions when both futures and options can be used in an expected utility model of price and basis uncertainty when futures and option prices are unbiased optimal hedging requires only futures options are redundant options are used together with futures as speculative tools when market prices are perceived as biased straddles are used to speculate on beliefs about price volatility and to hedge the futures position used to speculate on beliefs about the expected value of the futures price mean variance analysis in general is not consistent with expected utility when options are allowed one extension of sandmo s expected utility model of the competitive firm under price uncertainty considers the use of futures or forward contracts danthine holthausen and feder just and schmitz show that without basis uncertainty the optimal output level is not affected by price risk also with an unbiased futures price the optimal hedging level of the competitive firm is the full hedge while a biased futures price will result in a partly speculative hedge related works include batlin who allows for basis risk in the form of imperfect time hedging paroush and wolf and antonovitz and nelson who consider basis risk with the simultaneous availability of futures and forward contracts grant honda losq newbery and stiglitz and rolfo who allow for production uncertainty chavas and pope who allow for production uncertainty and hedging costs and karp who considers the problem in a dynamic setting this paper provides a further extension of this analysis by allowing options as a means of coping with price risk with the introduction of commodity options on futures for many commodities in the 1980s this problem appears relevant to a number of production settings especially in agriculture specifically this paper considers the simultaneous choice of a production level and of hedging levels of futures and options within the general expected utility model the model allows for basis uncertainty but the production process is assumed to be nonstochastic

the preferred hedge instrument abstract the optimal choice of hedging instruments in futures and option markets is analyzed for a risk averse exporting firm that maximizes expected utility assuming unbiased futures and options prices optimal output and hedging decisions are derived it is shown that futures will unequivocally be preferred to options this preference for futures continues even if their price is adversely biased provided the bias is not too strong

hedging long term exposures with multiple short term futures contracts this article analyzes the problem facing an agent who has a long term commodity supply commitment and who wishes to hedge that commitment using short maturity commodity futures contracts as time evolves the agent has to roll the hedge as old futures contracts mature and new futures contracts are listed this gives rise to hedge errors the optimal hedging strategy is characterized in a world where contracts of several different maturities coexist the strategy is independent both of the agent s risk aversion and under certain conditions of beliefs about expected returns from holding futures contracts the methodology is compared with approaches based on dynamic models of the term structure it is tested on data from the oil futures market article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

currency options and the optimal hedging of contingent foreign exchange exposure foreign exchange transaction exposures over the complete range of probabilities as well the optimal forward and option hedge alternatives three utility functions are used covering a wide range of risk postures in marked contrast with the virtually universal endorsement of option hedging contingent exposures to be found in the financial management literature our results indicate that options have little if any useful role to play in the hedging of transaction exposures of any sort

the empirical minimum variance hedge decision making under unknown true parameters estimation risk is discussed along with bayes and parameter certainty equivalent pce criteria bayes criterion incorporates estimation risk in a manner consistent with expected utility maximization the pce method which is the most commonly used is not consistent with expected utility maximization bayes criterion is employed to solve for the minimum variance hedge ratio empirical application of bayes minimum variance hedge ratio is addressed and illustrated simulations shoe that discrepancies between prior and sample parameters may lead to substantial differences between bayesian and pce minimum variance hedges

optimal hedging in the futures market under price uncertainty abstract we show that there exists a simple optimal hedging rule in the futures markets for all risk averse decision makers given that a futures price today is an unbiased predictor of the futures price next period b basis is independent of the spot price

production uncertainty and the input decision of the competitive firm facing the futures market abstract production uncertainty is introduced into the model of the competitive firm facing the futures market the firm s input decision is shown to be highly sensitive to the nature of the production uncertainty

optimal hedging under biased energy futures markets abstract optimal futures hedging positions for those agents trying to maximize their expected utility will depend on their view about the evolution of the market and on how risk adverse they are the most risk adverse agents will probably decide to full cover their positions but when a futures bias exists hedgers with moderate or low degree of risk aversion can alter their strategy depending on the expected gains in futures markets in our application to the uk natural gas market we find a statistically significant time varying negative futures bias that can be forecasted with confidence as a result of this bias most effective and best performing hedging strategies for moderate risk averse agents are those involving short long hedging in winter summer with a hedging ratio above below the minimum variance hedge ratio these findings are of great interest to practitioners in the uk natural gas markets and the methodology can be extrapolated to other energy markets

the economic value of minimum variance hedges the present article examines the potential economic gains from better minimum variance hedge mvh estimates focusing on the assumptions that yield mvhs consistent with expected utility maximization it is found that the economic value of better mvh estimates is negligible and that optimal hedges are substantially different from mvhs when the usual mvh restrictions are relaxed among other things findings suggest that the hedging research s recent emphasis on better mvhs has been a waste of resources investigating the consequences of relaxing the standard mvh assumptions seems to be much more important than recent literature contributions

a simple multiperiod minimum risk hedge model a multiperiod hedging model is developed that is simpler than other multiperiod models in the literature the model permits periodic adjustment of the hedge while minimizing the producer s profit variance minimum risk hedge ratios are calculated for steers cows hogs corn and soybeans using the full model with hedge adjustments every two months these ratios are compared to those using the model without periodic hedge adjustments and to a simple single period model the results suggest that simple models may work well for simple hedges while the full model is best for more complex hedging situations such as cross hedges our purpose in this paper is to develop a multiperiod hedging model in which the hedge can be updated each period other multiperiod hedging models e g anderson and danthine karp have substantial data requirements which limit their use as viable hedging tools our aim is to develop a simpler model that will have practical application the model is used to calculate minimum risk hedge ratios for steers cows hogs corn and soybeans and these ratios are compared with hedge ratios based on a multiperiod model in which the hedge cannot be adjusted each period simple minimum risk hedge ratios also are computed for each commodity and compared with the other ratios