Better cross hedges with composite hedging? Hedging equity portfolios using financial and commodity futures

Abstract

Unless a direct hedge is available, cross hedging must be used. In such circumstances portfolio theory implies that a composite hedge (the use of two or more hedging instruments to hedge a single spot position) will be beneficial. The study and use of composite hedging has been neglected; possibly because it requires the estimation of two or more hedge ratios. This paper demonstrates a statistically significant increase in out-of-sample effectiveness from the composite hedging of the Amex Oil Index using S&P500 and New York Mercantile Exchange crude oil futures. This conclusion is robust to the technique used to estimate the hedge ratios, and to allowance for transactions costs, dividends and the maturity of the futures contracts.

Keywords:

• composite hedging
• cross hedging
• Amex Oil Index
• contract maturity
• transactions costs

JEL Classification :

• G11
• G32

Acknowledgements

The authors wish to thank John Board, Gamal Selvarajah, Ghasan Shamsan and Thorsten Zimmermann for their input to earlier drafts of this paper, and the referees of this journal for their comments.

Notes

This paper does not consider generalized hedging, which occurs when multiple securities are hedged using multiple hedging instruments.

Since Amex Oil Index options had a very low level of liquidity, being delisted in April 2010, a hedging strategy using options was not pursued.

Since the aim is to hedge the risk of a basket of oil shares, it is assumed there are no non-financial risks and no financial constraints. In this case, linear hedging using futures is appropriate (Adam 2009).

Arithmetic, rather than logarithmic, returns are required to correctly compute the returns on the hedged portfolios. Returns were always computed using prices from the same contract.

For single hedges, and .

The M-GARCH model was not used for price changes because the variables are not stationary and the conditional variance is not well defined. The effectiveness measures in Table 6 are much higher than in previous tables because the regression equation uses levels not returns.