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Estimating optimal hedge ratio: a multivariate skew-normal distribution approach

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  • Donald Lien
  • Keshab Shrestha

Abstract

In this article, we adopt Multivariate Skew-Normal (MSKN) distributions to test for the joint normality of spot and futures returns and to estimate optimal hedge ratios. Using daily data for 22 different commodities, we reject the joint normality hypothesis in favour of Skew-Normal (SKN) distributions for all commodities at less than 1% significance level. In the out-of-sample performance comparison, the MSKN hedge ratio is found to outperform the conventional Minimum Variance (MV) hedge ratio for about half of the 22 commodities considered. On the other hand, the Lower Partial Moment (LPM) hedge ratio based on the MSKN dominates the LPM hedge ratio based on the multivariate normal distribution for almost all commodities in the out-of-sample comparison.

Suggested Citation

  • Donald Lien & Keshab Shrestha, 2010. "Estimating optimal hedge ratio: a multivariate skew-normal distribution approach," Applied Financial Economics, Taylor & Francis Journals, vol. 20(8), pages 627-636.
    • Handle: RePEc:taf:apfiec:v:20:y:2010:i:8:p:627-636
    DOI: 10.1080/09603100903459907
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    Cited by:

    1. Hou, Yang & Holmes, Mark, 2017. "On the effects of static and autoregressive conditional higher order moments on dynamic optimal hedging," MPRA Paper 82000, University Library of Munich, Germany.
    2. Wei-Han Liu, 2014. "Optimal hedge ratio estimation and hedge effectiveness with multivariate skew distributions," Applied Economics, Taylor & Francis Journals, vol. 46(12), pages 1420-1435, April.
    3. Stavros Degiannakis & Christos Floros, 2010. "Hedge Ratios in South African Stock Index Futures," Journal of Emerging Market Finance, Institute for Financial Management and Research, vol. 9(3), pages 285-304, December.
    4. Yang (Greg) Hou & Mark Holmes, 2020. "Do higher order moments of return distribution provide better decisions in minimum-variance hedging? Evidence from US stock index futures," Australian Journal of Management, Australian School of Business, vol. 45(2), pages 240-265, May.
    5. Barbi, Massimiliano & Romagnoli, Silvia, 2018. "Skewness, basis risk, and optimal futures demand," International Review of Economics & Finance, Elsevier, vol. 58(C), pages 14-29.

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