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The (De)merits of Minimum-Variance Hedging: Application to the Crack Spread

Author

Listed:
  • Carol Alexander

    (ICMA Centre, Henley Business School, University of Reading)

  • Marcel Prokopczuk

    (ICMA Centre, Henley Business School, University of Reading)

  • Anannit Sumawon

    (ICMA Centre, Henley Business School, University of Reading)

Abstract

We study the empirical performance of the classical minimum-variance hedging strategy, comparing several econometric models for estimating hedge ratios of crude oil, gasoline and heating oil crack spreads. Given the great variability and large jumps in both spot and futures prices, great care is required when processing the relevant data and accounting for the costs of maintaining and re-balancing the hedge position. We find that the variance reduction produced by all models are statistically and economically indistinguishable from the one-for-one 'naïve' hedge. However, margin and transaction costs produced by GARCH-based models are excessive. Therefore we encourage hedgers to use a na ¨ive hedging strategy on the crack spread bundles now offered by the exchange as it is the cheapest and easiest to implement. Our conclusion contradicts the majority of the existing literature, which favours the implementation of GARCH-based hedging strategies.

Suggested Citation

  • Carol Alexander & Marcel Prokopczuk & Anannit Sumawon, 2012. "The (De)merits of Minimum-Variance Hedging: Application to the Crack Spread," ICMA Centre Discussion Papers in Finance icma-dp2012-01, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2012-01
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    References listed on IDEAS

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    More about this item

    Keywords

    Hedging; Crack Spread; GARCH; Minimum-Variance Hedge;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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