A measure of hedging's performance

✍ Scribed by Ray D. Nelson; Robert A. Collins

• Publisher: John Wiley and Sons
• Year: 1985
• Tongue: English
• Weight: 640 KB
• Volume: 5
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.3990050106

✦ Synopsis

A expected utility maximizer finds widespread acceptance, variance comparisons continue to dominate evaluations of futures contracts as hedges. The addition of futures to a portfolio alters its return as well as its risk. Variance comparisons elaborate only the risk reducing benefits of hedging and ignore the equally important costs or benefits resulting from the effect of futures on the expected return of the portfolio.

This article suggests a single parameter performance measure of futures as hedges which jointly incorporates both risk and return. The discussion of this parameter proceeds by first summarizing previous conceptual and empirical appraisals of hedging's effectiveness. Then a review of the applicable economics and finance literatures identifies the excess return to variability ratio as an appropriate performance measure. Finally, an illustration demonstrates the relevance of the ratio.

HEDGING'S EFFECTIVENESS

Gray and Rutledge (1971) identify four distinct approaches to hedging in their comprehensive survey of the futures literature. Since the publication of this survey no significant additions appear in the first Gray-Rutledge category, hedges as a type of insurance. Some authors, however, mention this category while denouncing the absurdity of risk elimination in order to emphasize the reality of their own approach to hedging.

Although many new appearances in the literature base their arguments on portfolio concepts, they nonetheless emphasize risk reduction, the second Gray-Rutledge category. These models typically compare the variances of open and hedged positions. Ederington (1979) establishes a methodology which compares the respective