Hedging long-term commodity risk

✍ Scribed by Yulia V. Veld-Merkoulova; Frans A. de Roon

• Publisher: John Wiley and Sons
• Year: 2002
• Tongue: English
• Weight: 177 KB
• Volume: 23
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.10060

✦ Synopsis

Abstract

This study focuses on the problem of hedging longer‐term commodity positions, which often arises when
the maturity of actively traded futures contracts on this commodity is limited to a few months. In this case,
using a rollover strategy results in a high residual risk, which is related to the uncertain futures basis. We use
a one‐factor term structure model of futures convenience yields in order to construct a hedging strategy
that minimizes both spot‐price risk and rollover risk by using futures of two different maturities. The
model is tested using three commodity futures: crude oil, orange juice, and lumber. In the
out‐of‐sample test, the residual variance of the 24‐month combined spot‐futures
positions is reduced by, respectively, 77%, 47%, and 84% compared to the variance of a
naïve hedging portfolio. Even after accounting for the higher trading volume necessary to maintain a
two‐contract hedge portfolio, this risk reduction outweighs the extra trading costs for the investor with
an average risk aversion. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:109–133, 2003