Hedging long-term commodity risk

• Published in: The journal of futures markets Vol. 23; no. 2; pp. 109 - 133
• Main Authors: Veld-Merkoulova, Yulia V., de Roon, Frans A.
• Format: Journal Article
• Language: English
• Published: New York Wiley Subscription Services, Inc., A Wiley Company 01.02.2003; Wiley Periodicals Inc
• Subjects: Agricultural commodities; Commodities; Crude oil; Economics; Expected utility; Finance; Fruit juices; Futures; Hedging; Hypotheses; Mathematical models; Prices; Risk; Risk aversion; Securities markets; Statistical analysis; Studies; United States > US
• ISSN: 0270-7314; 1096-9934
• DOI: 10.1002/fut.10060

This study focuses on the problem of hedging longer‐term commodity positions, which often arises when the maturity of actively traded futures contracts on this commodity is limited to a few months. In this case, using a rollover strategy results in a high residual risk, which is related to the uncertain futures basis. We use a one‐factor term structure model of futures convenience yields in order to construct a hedging strategy that minimizes both spot‐price risk and rollover risk by using futures of two different maturities. The model is tested using three commodity futures: crude oil, orange juice, and lumber. In the out‐of‐sample test, the residual variance of the 24‐month combined spot‐futures positions is reduced by, respectively, 77%, 47%, and 84% compared to the variance of a naïve hedging portfolio. Even after accounting for the higher trading volume necessary to maintain a two‐contract hedge portfolio, this risk reduction outweighs the extra trading costs for the investor with an average risk aversion. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:109–133, 2003