Derivative pricing model and time-series approaches to hedging: A comparison

✍ Scribed by Henry L. Bryant; Michael S. Haigh

• Publisher: John Wiley and Sons
• Year: 2005
• Tongue: English
• Weight: 214 KB
• Volume: 25
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.20163

✦ Synopsis

This research compares derivative pricing model and statistical time-series approaches to hedging. The finance literature stresses the former approach, while the applied economics literature has focused on the latter. We compare the out-of-sample hedging effectiveness of the two approaches when hedging commodity price risk using futures contracts. For various methods of parameter estimation and inference, we find that the derivative pricing models cannot out-perform a vector error-correction model with a GARCH error structure. The derivative pricing models' unpalatable assumption of deterministically evolving futures volatility seems to impede

The first author gratefully acknowledges the support of the Tom Slick Senior Graduate Research Fellowship from the College of Agriculture and Life Sciences at Texas A&M University. Helpful comments were provided by David Bessler. Thanks to those whose public license Cϩϩ code was used: Robert Davies ("Newmat" matrix library) and Todd Knarr ("Date" class). The views expressed in this paper are those of the authors and do not, in any way, reflect the views or opinions of the U.S. Commodity Futures Trading Commission.