MINIMUM VARIANCE HEDGING AND THE ENCOMPASSING PRINCIPLE: ASSESSING THE EFFECTIVENESS OF FUTURES HEDGES

Mark Manfredo and Dwight R. Sanders

No 22247, 2003 Annual meeting, July 27-30, Montreal, Canada from American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association)

Abstract: An empirical methodology is developed for statistically testing the hedging effectiveness among competing futures contracts. The presented methodology is based on the encompassing principle, widely used in the forecasting literature, and applied here to minimum variance hedging regressions. Intuitively, the test is based on an alternative futures contract's ability to reduce residual basis risk by offering either diversification or a smaller absolute level of basis risk than a preferred futures contract. The methodology is also easily extended to cases involving multiple hedging instruments and general hedge ratio models. The methodology is demonstrated by evaluating the hedging effectiveness of Chicago Board of Trade's (CBOT) corn futures versus the Minneapolis Grain Exchange's National Corn Index (NCI) futures. The results indicate that the NCI futures encompass the CBOT futures for hedging country-level corn price risk in North Central Iowa; but, the NCI and CBOT futures are complementary in hedging terminal-level corn price risk at the U.S. Gulf.

Keywords: Agribusiness (search for similar items in EconPapers)
Pages: 22
Date: 2003
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Persistent link: https://EconPapers.repec.org/RePEc:ags:aaea03:22247

DOI: 10.22004/ag.econ.22247

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