Crude oil hedging strategies using dynamic multivariate GARCH

• Published in: Energy economics Vol. 33; no. 5; pp. 912 - 923
• Main Authors: Chang, Chia-Lin, McAleer, Michael, Tansuchat, Roengchai
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.09.2011; Elsevier; Elsevier Science Ltd
• Series: Energy Economics
• Subjects: Applied sciences; Conditional correlations; Crude oil; Crude oil prices; Economic data; Economics; Energy; Energy economics; Energy policy; Exact sciences and technology; Fossil fuels and derived products; Futures; Futures market; GARCH models; General, economic and professional studies; Hedging; Hedging strategies; Markets; Methodology. Modelling; Multivariate GARCH; Multivariate GARCH Conditional correlations Crude oil prices Optimal hedge ratio Optimal portfolio weights Hedging strategies; Oil; Oil market; Oil price; Oil resources; Oil supply; Optimal hedge ratio; Optimal portfolio weights; Petroleum industry; Portfolio management; Portfolio selection; Price formation; Risk management; Stochastic models; Studies; Volatility; Crude oil prices; C22; Optimal hedge ratio; C32; G11; G32; Optimal portfolio weights; Hedging strategies; Conditional correlations; G17; Multivariate GARCH
• ISSN: 0140-9883; 1873-6181
• DOI: 10.1016/j.eneco.2011.01.009

The paper examines the performance of several multivariate volatility models, namely CCC, VARMA-GARCH, DCC, BEKK and diagonal BEKK, for the crude oil spot and futures returns of two major benchmark international crude oil markets, Brent and WTI, to calculate optimal portfolio weights and optimal hedge ratios, and to suggest a crude oil hedge strategy. The empirical results show that the optimal portfolio weights of all multivariate volatility models for Brent suggest holding futures in larger proportions than spot. For WTI, however, DCC, BEKK and diagonal BEKK suggest holding crude oil futures to spot, but CCC and VARMA-GARCH suggest holding crude oil spot to futures. In addition, the calculated optimal hedge ratios (OHRs) from each multivariate conditional volatility model give the time-varying hedge ratios, and recommend to short in crude oil futures with a high proportion of one dollar long in crude oil spot. Finally, the hedging effectiveness indicates that diagonal BEKK (BEKK) is the best (worst) model for OHR calculation in terms of reducing the variance of the portfolio.