he purpose of measuring hedging effectiveness is to express the useful-T ness of trading a futures contract, based on comparing the results of a combined cash-futures portfolio and the cash position alone. The traditional approach pioneered by Ederington (1979) is only appropriate if the single objective of hedging is to minimize the hedger's risk. The Howard and D'Antonio (1984) measure of hedging effectiveness takes into account both return and risk characteristics of the futures contract, but it suffers from other deficiencies.
This article develops two new hedging effectiveness measures, which incorporate both payoff and risk considerations. Closed-form expressions are offered for both,
The first one expands the approach of Howard and D'Antonio in several ways. Use of monetary payoff amounts rather than relative returns avoids the problem discussed in the hedging literature of defining the (percentage) return on a futures contract. Since no money (except margin requirements) has to be paid at the time of investment, a straightforward calculation of this return is impossible. Furthermore, Chang and Shanker (1986) observe a problem with the Howard and D'Antonio measure when the excess return of the cash position is negative: Then, the higher the effectiveness, the lower the value of the measure. The measure presented here circumvents this difficulty, and therefore, no remedy like Chang and Shanker's is necessary. Also, including margins and transaction costs, the effect on the closed-form expression of hedging effectiveness will be shown.
The second measure of hedging effectiveness is introduced to render a closer description of the individual's benefit of trading a futures contract.