Comparing The Performances Of The Partial Equilibrium And Time-Series Approaches To Hedging

This research compares partial equilibrium 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 a simple derivative with a linear payoff function (a futures contract). For various methods of parameter estimation and inference, we find that the partial equilibrium models cannot out-perform the time series model. The partial equilibrium models unpalatable assumptions of deterministically evolving futures volatility seems to impede their hedging effectiveness, even when potentially foresighted option-implied volatility term structures are employed.