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40
A Critique of Minimum Variance Hedging
the hedge is exposed to basis risk (defined as follow a martingale process where2
the variance of the basis). Basis risk means that Et ( Ft + r Ft ) = 0 . (2)
the gain or loss on reversal of the hedge is
uncertain. It is this type of hedge which has Partial hedging ( 0 < < 1 ) allows the
received the most attention in the literature, and hedger to determine the optimal tradeoff
is the focus of this paper. between spot price risk and basis risk.
The hedge is viewed as a two security
2.1 Nave hedging and Workings approach
portfolio consisting of spot and futures
The nave approach sees the primary
positions. It is assumed that the hedger has an
motivation for hedging as risk reduction and
expected mean variance utility function. This
sets =1. If the value of the change in the
preference function assumes either quadratic
spot equals the value of the change in the
preferences or normally distributed returns. It is
futures ( St + r St = Ft + r Ft ), there is no
assumed that the hedger has a given spot
basis risk and the hedgers wealth remains
position of one unit and seeks to maximise
unchanged. Alternatively, the hedgers wealth
expected profit adjusted for risk at time (t+r).
remains unchanged given that the gain or loss
The hedger therefore seeks to maximise the
on the hedge is equal to the change in the basis
following objective function ()
( Ft St ) ( Ft + r St + r ) which is equal
to zero. Under these circumstances, the spot Max ( ) = Et ( t + r ) 2
t +r
(3)
price risk has been eliminated completely and
where represents the risk aversion
parameter, Et ( t + r ) represents the expected
the hedger has locked in the spot price at
time t. If the spot and futures markets do not
profit from the hedge between time t and time
move together perfectly, the hedger is exposed
t+r
to basis risk, with the change in the basis
resulting in a change in wealth. Nave hedging Et ( t + r ) = Et ( St + r St ) Et ( Ft + r Ft ) (4)
therefore completely eliminates spot price risk
and t +r represents the variability in hedged
2
and replaces it with basis risk. Risk reduction
portfolio returns
only occurs if the variance of the basis is less
than the variance of the spot. 2 = s2 + 2 2f 2 sf
t +r
(5)
Working (1953a, 1953b, 1961) was critical
where s is the spot variance, f is the
2 2
of the nave approach, given its failure to
futures variance and sf is their covariance.
incorporate changes in the basis into the
Equations 4 and 5 reveal that different
hedging decision. Working assumed that
combinations of risk and return can be
hedges were motivated by the desire to profit
generated by varying the hedge ratio, 3. The
from favourable changes in the basis, with risk
hedge ratio is found by maximising Equation 3
reduction being incidental. Assuming a long
with respect to (Sephton, 1993)
spot position, if the basis was expected to fall,
the hedger would set = 1. If the basis was E (F F )
= sf2 t t + r 2 t . (6)
expected to rise, the hedger would not hedge at f 2 f
all, with = 0.1
Hedge ratio determination requires an
2.2 The conventional approach expected futures price Et ( Ft + r ) , plus a
Ederington (1979), Figlewski (1986) and measure of risk aversion, . The MVHR
Castelino (1992) overview the development of overcomes these issues by minimising the
the conventional approach which originated variability in the expected hedged return
from the work of Johnson (1960) and Stein
(1961). The conventional approach allows for
futures bias and partial hedging. Futures bias 2 If futures are biased the equality in Equation 2 does not
means that the futures are biased predictors of hold. Allowing for futures bias is important, given that it
may result in significant hedging losses. To illustrate,
the spot. If futures are unbiased the futures under a long spot/short futures hedge, if the futures are
downward biased, there will be a loss on reversal of the
futures position.
1 See Ederington (1979), Castelino (1992) and Brown 3 This may also be represented diagrammatically, see
(1985) for further discussion. Ederington (1979) and Cecchetti et al (1988).
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 1 (2005)
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A Critique of Minimum Variance Hedging
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 1 (2005)
Table 1
Summary of the literature investigating the performance of MVHRs
Reference Data MVHRs Dynamic Comments regarding risk
strategy reduction
Cecchetti 20 yr T-bond Biv-ARCH(3) Single Time invariant MVHR
et al (1988) Monthly, 1/78- period inappropriate.
12/83
Baillie and Commodities OLS, Single Time invariant MVHR
Myers Daily, 82-86 Biv-GARCH period inappropriate.
(1991) (periods vary) GARCH outperforms OLS.
Myers Wheat Weekly, OLS, Single MVHRs are time varying, however
(1991) 6/77-5/83 Biv-GARCH period the GARCH models performance
is only marginally better. Suggested
that once transaction costs are taken
into account, the OLS strategy is
probably the preferred strategy.
Sephton Commodities OLS, Single Time invariant MVHR
(1993) Daily, 5/88- Biv-GARCH period inappropriate.
5/89 GARCH outperforms OLS.
Kroner and Currencies vis- Nave,OLS, Single Biv-EC-GARCH provides best
Sultan a vis USD Biv-ECM, period performance (with and without
(1993) Weekly, 2/85- Biv-EC-GARCH transaction costs).
2/90
Lien and Currencies OLS, Multi- OLS and Biv ECM hedge
Luo (1994) vis--vis USD, Biv ECM, period outperform the Biv-EC-GARCH.
Weekly, 3/80- Biv-EC-GARCH
12/88
Park and S&P500, Nave, Single Biv-EC-GARCH hedge provides
Switzer Toronto 35 OLS, ECM, period superior performance (with and
(1995) Weekly, 6/88- Biv-EC-GARCH without transaction costs).
12/91
Koutmos Commercial OLS, Single Biv-EC-GARCH provides best
and Pericli paper with T- Biv-GARCH, period performance (with and without
(1998) bill futures, Biv-EC-GARCH transaction costs). Both
Weekly, cointegration and time varying
1/85- 3/96 moment estimation improves
hedging performance.
Lien and Nikkei 225 OLS, VAR, Single Including GARCH improves
Tse (1999) Daily, 1/89- ECM, period hedging performance. EC-GARCH
8/97 Biv-VAR/EC- is the dominant strategy. OLS
GARCH provides the worst performance.
OLS = ordinary least squares estimation via Equations 7 & 8. ECM = error correction model estimation,
Equations 7 & 10. Biv-GARCH/Biv-EC-GARCH = dynamic estimation of Equation 9 using bivariate
GARCH/bivariate error correction GARCH.
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A Critique of Minimum Variance Hedging
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 1 (2005)
with certainty. This ignores estimation risk, internal cashflows used to finance an
which arises from less than perfect information investment project.
about the functional form of the PDF or its In summary there is a vast literature that
parameter values. Failure to recognise the seeks to address the limitations in the
estimation risk means that under the PCE conventional MVHR. Unfortunately an
approach, slight changes in data sets can result approach that simultaneously addresses all of
in large changes in the estimated MVHR. these limitations has not been forthcoming. The
Lence (1995) extends this further by arguing conventional MVHRs use of the mean variance
that the conventional MVHR ignores framework is one further possible limitation
estimation risk, commissions, margins and the and is the subject of the next section.
lumpiness of contracts. It also fails to allow for
simultaneous borrowing, lending or investing 4. Limitations in the mean variance
in other assets. The MVHR is determined via framework
the Lagrangian technique, where end of period The conventional approach employs a mean-
wealth is maximised subject to a number of variance framework assuming that
linear constraints. The magnitude of the hedge maximisation of the objective function
ratio is shown to be very sensitive to the (Equation 3) results in utility maximisation.
relaxation of the assumptions in the This however is not necessarily the case, given
conventional MVHR. that the MVHR equals the utility maximising
3.2.5 Hedging with futures and options hedge ratio only if the hedger has a quadratic
The above approaches assume that the only utility function or normally distributed profits
derivative available for hedging is a futures (Kahl, 1983).
contract. Lence et al (1994), Moschini and Arrow (1971) argues that quadratic utility is
Lapan (1995), Sakong et al (1993) and Froot et highly implausible given that it implies
al (1993), demonstrate that hedging a non- increasing absolute risk aversion. This suggests
linear payoff in the spot, requires the use of that as an individual becomes wealthier, they
options and futures. This is because a position will decrease the amount of risky assets held.
in futures and options can create an offsetting The normality requirement also appears
non linear payoff, in contrast to futures, that unlikely in most financial markets, with return
only provide offsetting linear payoffs. distributions exhibiting leptokurtosis and
Moschini and Lapan (1995) and Sakong et skewness. Nonetheless Levy and Markowitz
al (1993) show how a non-linear spot payoff (1979) argue that regardless of the utility
can be a result of the interaction between price function or the distribution of returns, the
and production yield uncertainty (a quantity maximisation of a mean-variance objective
risk). These results are based on a one period function may provide a reasonable
model, given the assumption that the firm is approximation of the true objective function.
only concerned with a single production cycle. The MVHR is therefore utility maximising
Lence et al (1994) allow for two production if: a) at least one of the conditions for the
cycles which is appropriate for firms that conventional approach to be utility maximising
exhibit forward looking behaviour. It is argued is met; and b) the futures are unbiased or the
that output price changes in one period will hedger is extremely risk averse. For example,
change the perceived relationship between next Giaccotto et al (2001) show that the MVHR
periods input and output prices. Lence et al equals the utility maximising hedge ratio if
(1994) show that under these circumstances utility is represented as a general von Neuman-
and non stochastic production, there will be a Morgenstern utility function (a more general
non linear payoff in the subsequent period that utility function than the quadratic utility
can be hedged with futures and options. Froot function), the variables are normally
et al (1993) also employ a two period approach distributed, and futures prices follow a
to examine the impact of hedging on optimal martingale process.
financing and investment decisions. A number Given that the conditions required for the
of situations are presented where a non linear conventional MVHR to be utility maximizing
hedging strategy is required to hedge the are quite restrictive, other approaches may
46
A Critique of Minimum Variance Hedging
provide superior outcomes (given that they are of the methods used to estimate MVHRs. The
utility maximising). Consequently the hedging paper then highlighted some of the weaknesses
outcomes using the conventional MVHR may in the approach. The conventional approach
be dominated stochastically. Stochastic does not allow for multiple exposures, multiple
dominance is based on the von Neumann- periods, basis convergence, estimation risk, or
Morgenstern utility functions and applies the use of futures and options. It was shown
selection rules that are based on pairwise that if a hedger is not extremely risk averse and
comparisons between distributions that require uses the conventional MVHR, this may not
knowledge of the complete distribution. This is maximise the hedgers objective function.
in contrast to the mean-variance approach Limitations in the mean variance framework
which only requires knowledge of the mean may also mean that the use of alternative risk
and variance. See Bawa (1975, 1978), Fishburn measures are required. Given the limited
(1977), Yitzhaki (1982), Shalit and Yitzhaki benefits from employing more sophisticated
(1984) for further details. estimation methods, the literature should
Given that the conventional approach may probably focus more of its attention on the
not be utility maximising, alternative measures assumptions underlying the MVHR, rather than
of risk have been used to derive hedge ratios. improving the estimation techniques.
Chen et al (2001) discuss the alternative risk
measures used in the hedging literature, namely References
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ACCOUNTING RESEARCH JOURNAL VOLUME 18 NO 1 (2005)
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A Critique of Minimum Variance Hedging
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