Minimizing Risk Techniques for Hedging Jet Fuel: an Econometrics Investigation

Radu Tunaru1 Middlesex University

Mark Tan

Business School, London NW4 4BT

Abstract

The aim of this paper is to discuss the hedging techniques that a company based in an emerging market country can use to hedge the risk associated with jet fuel or kerosene. The company can be an airline company or a market intermediary offering contracts on this important commodity. An empirical analysis reveals two main directions for minimum risk hedging: one is to cross-hedge directly the commodity itself using the futures contract on another commodity or a basket of commodities highly correlated with jet fuel; the second is to use the futures contract on kerosene in Tokyo and then the problem is transformed into cross hedging the currency.

JEL classification: G13, G15, F31 Keywords: cross hedging; regression models; emerging market; kerosene; exchange rates

Address for correspondence: Radu Tunaru, Business School, Middlesex University, The Burroughs, London NW4 4BT, r.tunaru@mdx.ac.uk ; tel: 020 8411 4258.

1. Introduction 1.1 Managing risk associated with oil prices Deregulation in the early 1970s dramatically increased the degree of price uncertainty in the energy markets, prompting the development of the first exchange traded derivative securities. Oil futures contract has been traded on NYMEX since October 1974. The worlds first successful energy contract, heating oil futures was opened at NYMEX in 1978. Contracts followed between 1981 to 1996 for gasoline, crude oil, natural gas, propane and electricity. Serletis and Kemp (1998) presented evidence in favour of correlations between heating oil, unleaded gasoline, and natural gas prices with crude oil price in the US. Singapore International Monetary Exchange (SIMEX) launched fuel oil futures contracts in February 1989 but failed to attract businesses from OTC market. In spite of modifications to contract specification at the end of 1997 the contract lost any interest. Horsewood (1997) pointed out that the contract failed because it was not providing an exact hedge against the underlying physical and because of liquidity problems due to government control such as Malaysia. However, various futures contracts on refined oil products have been launched recently in Tokyo and Hong Kong. In recent times oil prices have been volatile, ranging from as low as $10/bbl in 1999 to over $35/bbl in 2000 when it caused shortages in Americas Mid-Western States in Summer and the fuel riots which paralysed several European countries in September. The cause of recent energy crisis (1999-2001) are different from those that produced the oil shocks of the 1970s and the lesser upsets during the Gulf War in 1990s. OPEC has been working with oil consuming nations to stabilise energy prices. Considine and Heo (2000) used Generalised Method of Moments to perform dynamic, simultaneous simulations to estimate the impact of supply and demand shock in petroleum markets. Market price of petroleum products now appear quite sensitive to supply and demand shocks, unlike

the previous era of pricing under long term contracts.

1.2 Jet fuel or kerosene: a problematic commodity According to Co (2000) fuel constitutes 10-20% of airline costs and a 5% change in fuel price affects profitability considerably. The cost of jet fuel accounts for 10-15% of Swiss Air total operating costs (Khan, 2000). It is almost impossible for an airline company to stock large amounts of kerosene, due to the cost of financing, storage cost and location required to refuel the airplanes. The jet fuel price risk may depend on the pricing location, volume and whether forward sales commitments have been made (Bullimore, 2000).

Table 1. List of refined products in percentages obtained from a barrel of crude oil Product Gasoline Distillate Fuel Oil
(includes both home heating oil & diesel)

Gallons per Barrel 19.5 9.2 4.1 2.3 1.9 1.9 1.8 1.3 1.2 0.5 0.2 0.3

Kerosene Residual Fuel Oil

(heavy oils used as fuels in industry, marine transport and electric power generation)

Liquefied Refinery Gases Still Gas Coke Asphalt and Road Oil Petrochemical Feedstock Lubricants Kerosene Other Source: www.CommoditySeasonals.com

Figures are based on 1995 average yields for US refineries. One barrel of oil contains 42 gallons. Excess due to processing gain.

The major price element in kerosene is the price of crude oil because kerosene is one of the refined products from crude oil, a list of those products being presented in Table 1. There is also empirical evidence that kerosene prices are co-integrated with crude oil prices (Errera and Brown ,1999 ). The main purpose of this paper is to outline a methodology supported by empirical investigation of how an airline company or market intermediary based in an emerging country can hedge its operations related to kerosene. For example, how can Malev (Hungary) or Tarom (Romania) or Olympus (Greece) hedge the risk associated with volatility of kerosene prices? In essence the same question is valid for all emerging market countries, European or Asian or Latin American and the success of minimising the risk of this important commodity may prove to be the decisive factor in the survival of the company. One may expect to be able to hedge using futures contracts on kerosene. Airline companies operate worldwide but there are no futures contracts on kerosene on most of the major exchanges excepting Tokyo. This provides an opportunity to investigate in this paper whether airline companies outside Japan are better off hedging using kerosene futures in Tokyo or cross hedging kerosene by using gas oil and heating oil as underlying in own country or nearest exchange. For companies that operate outside Japan as it is the case with all emerging markets, hedging jet fuel or kerosene is transformed into a problem of managing foreign exchange risk.

The transfer of the problem from commodity world to the currency world, technically speaking is the same because many of the emerging markets do not have a futures contract on the exchange rate with the Japanese yen or U.S. dollar. In both situations, commodity or currency, a perfect hedge is not possible and a cross-hedge that only minimises the risk is investigated.

2. The Evolution of Cross-Hedging Techniques Hedging via the futures markets is not always straightforward and one has to overcome problems such as mismatch of either the maturity date or underlying asset, or both. The former leads to delta-hedge, the latter to cross-hedge and when both are in place to cross delta hedge. The seminal ideas go back almost half a century and the usual approach is due to Johnson (1960), Stein (1961) and Ederington (1979). A wider perspective on cross hedging in a risk return framework is described by Anderson and Danthine (1981). It is now a common subjects in textbooks such as Stoll and Whaley (1993) and Ritchken (1996), to name just a few, and yet there is still an ongoing debate about what techniques are more useful. For our purposes two major classes of cross-hedging examples: commodity cross-hedging and currency cross-hedging. Although it has been shown that it is possible to cross-hedge commodity with currency as hinted by Sadorsky (2000) and currency with commodity as in Benet (1990), in this paper we consider only the case of two markets from the same class, one a futures market and the other a spot market with different but correlated underlyings. Probably the most used methods for calculating the optimal hedge ratio are regression based methods. As always with statistics the solution comes with advantages and disadvantages and for the financial analyst this can develop into a black whole. There are three types of regression models used: price level, price change level and percentage change level. We denote by S(t) the spot price of the underlying targeted for hedging at time t and by FT(t) the futures price at time t of the proxy underlying with maturity time T. The maturity of futures contracts is most of the time after the hedging period. In other words if T1 is the exposure period for the hedging the futures contracts used for cross hedging have a maturity T2 > T1 . In this paper we consider only the situation of minimising the risk of holding a portfolio of the underlying under the hedging and futures contracts of one or several of its proxies. Shorting 0 futures of one proxy for each long position in the spot leads to a cash flow at time T1 equal to

S (T1 ) 0 FT2 (T1 ) + 0 FT2 (0)

(1)

Minimising the variance of this cashflow leads to

0 =

cov0 ( S (T1 ), FT2 (T1 )) var0 ( FT2 (T1 ))

(2)

The optimal coefficient 0 depends on the horizon of exposure to hedging T1 and the futures maturity T2 . In practice it is often assumed that it is constant with respect to time although some studies suggest that this is not always the case. We shall treat this assumption with caution but for sake of simplicity we shall drop the index and refer to the optimal hedge ratio as simply . The formula given in (2) can be also recovered from a simple regression model such as
S (t ) = + FT2 ( t ) (t ) + t

(3)

where FT2 ( t ) (t ) is the price of the futures contract at time t with T2 (t ) the nearest maturity available.

The estimate of the optimal hedging ratio depends on the historical data. In order to solve problem related to autocorrelation, many authors prefer a regression at the price change level. Thus, is estimated from
S (t ) S (t 1) = + FT2 (t ) (t ) FT2 (t 1) (t 1) + t

(4)

There might still be problems with the regression in (4) such as heteroscedasticity and then a percentage change level regression is often used. This is
FT2 (t ) (t ) S (t ) 1 = a + b 1 + t FT (t 1) (t 1) S (t 1) 2

(5)

The hedge ratio is calculated from the estimated slope of this regression using the formula

=b

S (t*) FT2 ( t *) (t*)

(6)

where t* is the last day in the estimation sample.

When simple linear regression methods are used the R 2 is a measure of the efficiency of the hedging. The theoretical support is provided by Ederington (1979), Dale (1981) but some research Chang and Fang (1990) indicated that this measure is not always appropriate and other measures of efficiencies may be more useful. However, the R 2 is still largely used in practice for its direct interpretability and ease of calculation especially in conjunction with regression based methods.

2.1 Cross-hedging commodity

The basic principles of hedging can be used for many commodities for which no futures contract exists, because often they are similar to commodities that are traded. Witt et al. (1987) compare the analytical approaches for estimating hedge ratios for agricultural commodities and discuss various issues related to regression based methods. Our interest is jet fuel or kerosene, a commodity that could be hedged by using heating oil futures contracts. Brent crude oil and its related refined products prices are co-integrated as shown by Gjolberg and Johnsen (1999), who also argue that the regression estimates used for establishing a risk minimising hedge may be biased because standard approach for establishing a risk minimising hedge may yield biased estimates. In energy market, basis risk is an ever-present ingredient in hedge selection. Distribution of prices in energy market is not as unbounded as in foreign exchange, because operating costs and constraints tend to underpin downward price movement (Moonier and Potter 1998). However, other economic reasons such as transfer costs, storage costs and location may lead to very interesting cross hedging problems. One good example is Woo et al (2001) where cross hedging in power utilities markets is discussed. Unrelated commodities have a persistent tendency to move together (Pindyck and Rotemberg 1990). They also found that an equally weighted index of the dollar value of British pound, German mark, and Japanese yen negatively and significantly impacts the price of crude oil in both OLS

regressions and latent variable models. Sadorsky (2000) also showed that futures prices for oil related products are co-integrated with a traded-weighted index of exchange rates and that energy sector is important to some countrys trade, suggesting sensitivity to the exchange rate.

2.2 Cross-hedging currency

There is a large literature concerning cross hedging currencies. For our purposes later in this paper it is useful to be aware of some of the previous research conclusions in this area. The basic reason for cross hedging currencies is that currency futures only matures four times a year, so perfect hedge are co-incidental (Lypny, 1988). Dale (1981) uses spot and futures prices level for his analysis on currencies but Hill and Schneeweis (1981) insisted that price change level should be used instead of price level in order not to violate the Ordinary Least Square (OLS) assumptions because of the correlations of error terms in regression models. Grammatikos and Saunders (1983) also used a simple OLS regression model. The use of this model over a long period of time affects the stability of the regression slope coefficient (). Grammatikos and Saunders (1983) proposedoverlapping regressions procedures, aiming to test shifts in coefficients overtime, and a Random Coefficient Model (RCM) to test the optimal hedge ratio. Their results varied across countries. This was due to the complexity relationship of open interest, volume of contracts traded, the stability of the hedge ratio and the measure of hedging effectiveness. Lypny (1988) considered several strategies to derive an optimal hedging based on a portfolio of n-currency spot portfolio. It was shown that the portfolio strategy performed relatively well but a random coefficient model (RCM) supported the idea of intertemporal instability of at least one of the regression coefficients describing the portfolio effect. Mun and Morgan (1997) used generalised method of moments (GMM) model to analyse the performance of five major currency futures for

cross-hedging local currency/US dollar exchange rate risks faced by depository financial institutions in a selected group of emerging Asian countries: Indonesia, Korea, Malaysia, Singapore, and Thailand. The Sharpe Performance Index was used to assess cross hedging performance by country and the empirical evidence showed that minimum variance cross hedge outperforms an unhedged position. In terms of minimum variance cross hedge using a portfolio of futures contracts seems to be outperform the one-currency futures for some countries but under perform in other countries. Slee (1999) emphasized that the Sharpe ratio is not valid for measuring the effectiveness of hedging in the emerging market currencies because these currencies return can be significantly skewed. Another hedging alternative related to Asian currencies and described by Bannisters and Fong (1997) is based on non-deliverable forwards contracts. Companies can trade volatility of currency using covariance swap but as Carr and Madan (1999) pointed out the variance and covariance of different currencies are generally unstable over time. Exchange rate movements may be an important stimulus for commodity price changes (Sadorsky 2000). Many emerging markets allow their exchange rates to compete directly in the system of the dirty float. In this case hedging operations for these currencies are not easy. An innovative idea is described in Benet (1990). As a proxy for the foreign exchange the countrys best commodity in export terms can be used for cross-hedging. Firms often hedge as much as 75-85% of their foreign exchange exposure (Saunderson, 1999). When it is feasible, forwards and futures contracts are replaced with options, which can provide insurance against adverse market movements but still leave open the possibility of profit from positive price movements. Fallon (1998) proposed the use of basket currency options for hedging and meeting revenue target as well. He added that basket currency option are getting more and more popular by corporate treasury operations that manage risks on a centralised basis, as a way of hedging net income and for avoiding any shocks from currency volatility.

Eaker and Grant (1987) investigated the intertemporal instability of hedge ratios that causes hedged position to be riskier than unhedged positions. Overall cross hedging is shown to be a useful risk reduction technique but re-adjusting the hedging from time to time is important for a single currency cross hedge and overcomes problems of intertemporal instability of the coefficients. The instability of hedge ratios in time has been also pointed out by Park et al. (1987) who investigated the cross hedging performance of the U.S. futures market relative to the currencies from the European monetary system. They used a price change simple regression model and their tests for stability were based on dummy variables. The cross hedging was done via the German DM futures, a contract also used by Braga et.al. (1989) in cross hedging the Italian lira / US dollar exchange rate. Recently, Sercu and Wu (2000) found evidence that for three-month currency exposures the price-based hedge ratios outperform the ratios estimated from regression models. One reason for this improved performance seems to be the adaptability of the price based ratios to breaks in the data.

3. Cross-hedging jet fuel

3.1 Data analysed

The data analysed is weekly data between 4th February 1997 and 21st August 2001, Tuesday continuous settlement prices and it is from Datastream. This sample of 204 observations is large enough to avoid well-known problems with estimation in small samples. The codes used are LCR Brent crude oil (IPE), NCL- light sweet crude oil (NYMEX), NHOheating oil (NYMEX), NHU- unleaded regular gas (NYMEX), NPG- liquid propane gas (NYMEX).

3.2 Regression based estimates

The correlations between the spot prices for kerosene and the futures prices for various proxy oil products may give us a hint to the problems that might appear when the regression models are fit to

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the data. Table 2 shows that jet fuel is highly correlated to almost all futures contracts on oil products traded in London or New York.

Table 2. Price level correlations; weekly data 4th February 1997 to 26th December 2000, Tuesday Settlement Prices

Table Price level correlation between jet kerosene and futures contracts JET LCR NCL NHO NHU NPG JET 1.00 LCR 0.92 1.00 NCL 0.96 0.94 1.00 NHO 0.97 0.91 0.97 1.00 NHU 0.91 0.93 0.97 0.92 1.00 NPG 0.90 0.90 0.92 0.94 0.86 1.00

The estimates from the simple regression model given by (3) can be misleading if the variables involved are random walks drifting apart over time. It is therefore essential to test the hypotheses that each price is a random walk. The test statistic employed is the Augmented Dickey Fuller (ADF) test discussed in detail in Davidson and MacKinnon (1993, Chapter 20). This is a two step procedure. First the simple linear regression model, where Pt is either the spot price or the futures price,
Pt = 0 + 1Pt 1 + t

(7)

is fitted under the standard normal assumptions and the residuals {dt } are saved. Then the regression model
dt = dt 1 + d t 1 + t

(8)

where the last term on the right side is a white noise, is fitted and the ADF statistic is simply the tstatistic for the OLS estimate of . Thus, this is a unit-root test. The results of unit root test are presented in Table 3.

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Table 3. The ADF statistics for random walk tests

*Significant at the 1% level and the null hypothesis is rejected It is obvious that the data rejects the null hypothesis of random walk for all series investigated and at all levels of significance. Secondly, to test whether the prices are drifting apart, a cointegration test can be done. This is also based on an ADF statistic and can be done in two steps. First, fit the simple linear regression model given by (3) and save the residuals {et } . Next, fit the regression model
et = et 1 + et 1 + t

Variable ADF statistics

JET

LCR

NCL

NHO

NHU

NPG

-10.29*

-9.20*

-10.60*

-12.61*

-9.96*

-8.93*

(9)

where the last term on the right side is a white noise, is fitted and the ADF statistic is simply the tstatistic for the OLS estimate of . For the series investigated here, the cointegration results are given in Table 4.

Table 4. ADF tests for cointegration between jet fuel spot and futures on other oil products.

*Significant at the 1% level and the null hypothesis is rejected

Variable ADF statistics

LCR -4.90*

NCL -3.96*

NHO -3.68*

NHU -2.84*

NPG -3.80*

Again the hypothesis that the spot prices and futures prices are drifting apart in time is rejected for all futures contracts under analysis. Having done that it seems that the only thing left is to use the regression model (3) to fit the data and use the estimate for the slope coefficient to determine the hedge ratio. The OLS results are illustrated in Table 5. The only fly in the ointment is the value of

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the Durbin-Watson statistic showing signs of positive autocorrelation in the data that will invalidate the nice OLS results. This is a typical case where researchers will change their regression model from a price level to a price change level. Although a large group of studies (Hill and Schneeweis, 1981; Park et al. ,1987; Braga et al. 1989 among many other) emphasized that using price level models is wrong due to obvious statistical problems we strongly agree with Witt et al. (1987) that the statistical first difference model is not congruent to the price change model. This is because the lag operator for price (percentage) change models takes differences as the change in prices over the time interval representing the hedge exposure and, as long as this exposure is not identical to the frequency of the data under the analysis, the autocorrelation may still be a problem if price differences are considered. Moreover, the exposure is not important for price level models because the same ratio can be used whereas when price change or percentage change models are employed the hedge ratio depends on the hedging period.

Table 5. OLS results for the simple regression model regressing the jet fuel oil on futures prices of proxy variable

Futures Contract LCR NCL NHO NHU NPG

2.222 0.444 1.668 0.381 5.098

t-statistics 3.166 0.857 3.939 0.473 7.281

1.110 1.127 39.339 37.547 48.485

t-statistics 32.755 47.844 55.827 30.675 28.871

Adjusted R2 0.84 0.92 0.94 0.82 0.80

DurbinWatson statistics 0.316 0.473 0.476 0.194 0.208

We also believe that most airline companies, although they might have some storage capacities, cannot afford to stock vast amounts of kerosene for long periods of time. Therefore, their

13

concern is the current futures price and the ending basis and price level models are relevant. If there is any problem with autocorrelation, a more appropriate solution would be to try and correct the estimates of the regression coefficients using a Cochrane-Orcutt procedure (see Davidson and MacKinnon, 1993, Chapter 10). The adjusted estimates are BLUE and they are given below in Table 6. One of the first things to be noticed is the change in the Durbin Watson statistic.

Table 6. Cochrane-Orcutt corrected estimates

Futures LCR NCL NHO NHU NPG

0.998 0.997 0.994 0.993 0.997

1 0.0424

t-statistics 0.466808

2 0.038978

t-statistics 0.457283

Adjusted R2 -0.00393

Durbin-Watson statistics 1.834391

0.0406

0.496997

0.416484

6.903424

0.187637

2.214941

0.0460 0.0941 0.0360

0.576674 1.132133 0.394835

19.09626 14.98603 5.596175

7.975026 6.494167 1.247208

0.236587 0.169320 0.002743

2.223238 2.120128 1.827963

3.3 Scholes Williams estimates

It is well-known that there is some non-synchronization between spot data and futures data. For poorly syncronized data we also calculate the Scholes and Williams (1977) instrumental variable estimator for the hedge ratio. This is given by
SW = cov(S (t ), IV (t )) cov(F (t ), IV (t ))

(10)

where

IV (t ) = F (t 1) + F (t ) + F (t + 1) = F (t + 1) F (t 2)

(11)

14

and S (t ) = S (t ) S (t 1) and F (t ) = F (t ) F (t 1) . For our data the SW estimates are given in Table 7.

Table 7. Scholes-Williams instrumental variable estimates

Independent variable (Futures)

LCR NCL NHO NHU NPG

SW estimator 0.03309 1.09439 32.1953 -29.75581 1.85632

4. Cross-hedging the currency

4.1 Data analysed

The data consists of 137 observations, weekly data from 19th January 1999 and 21st August 2001. The Tuesday settlement price is used and the data was from Datastream. The futures are traded either on NYMEX, or on CME or CBOT. In the first case, the most common one, the beginning of the code is FN, in the second case the beginning of the code is FI and in the last case the code starts with FC. For example FIBP is the exchange rate between the British pound and the U.S. dollar. All currency data are quoted per unit of US dollar. The following codes are used for emerging market currencies in empirical analyses: IR Indian rupee, RI- Indonesian Rupiah, HKUS- Hong Kong Dollars, TW -Taiwan Dollar , PPUS Philippines Peso, RMB China, Yuan Renminbi, RM - Malaysia Ringgit, SD -Singapore dollars, TB- Thailand Baht.

15

The following codes are used for the proxy exchange rates that are investigated for cross hedging operations: FCEU- Euro/USD, FIAD-Australian Dollars/USD, FIBP-British Pound/USD, FICD-Canadian Dollars/USD, FIDM-Deutsche mark/USD, FIFR- French Franc/USD, FIJY100Japanese Yen/USD, FIMX-Mexican Peso/USD, FINE-New Zealand Dollars/USD, FIRA-South African Rand/USD, FIRU- Russian Ruble/USD, FNYF-Swiss Franc/USD.

4.2 Regression based estimates

This section is in a sense similar to the analysis presented in Aggarwal and DeMaskey (1997). However, while they considered hedging portfolios of emerging currencies as foreign investments, therefore having their hedging operations in U.S., our position is quite the opposite. The problem here is to hedge the cash flows in currencies of emerging markets. Hence, in this section the cross hedge for emerging market currency to U.S. dollar is cross hedged via futures on one of the following Australian dollar, Japanese Yen, French franc, euro, Swiss franc or British pound to U.S. dollar. The analysis is done simultaneously for the Asian emerging countries like Hong Kong, Taiwan, Thailand, China, Philippines, Malaysia, Singapore. Appendix 1 contains information about the correlations between the various spot prices and futures prices. Together with other scatterplots (not shown here) they can be used as a preliminary screening procedure in order to determine what possible futures contracts to use for each emerging market currency. For each spot currency some of the highest correlation coefficients on the corresponding row are highlighted . As in the previous section, we test first that the pairs of spot price and futures price time series are not random walks and are not drifting apart. The ADF test results are shown in Appendix, showing that the series are related and move together. This should set up the scene for estimating the optimal hedge ratio from a simple linear regression model. However, the Durbin Watson statistics in Table 8 show that there are problems with autocorrelations and a Cochrane-Orcutt correction is needed.

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Table 8. OLS estimation results all variables being exchange rates to the U.S. dollar; the Durbin-Watson statistics showing problems with serial correlations
Dependent variable in bold Futures DurbinWatson statistics 0.209757 0.145103 0.266082 0.195351 0.302498 0.413604 0.178564 0.178884 1.350758 1.282225 1.321509 1.457320 0.172570 0.190013 0.246105 0.242981 0.116265 0.136339

7.583982 7.942936 59.55818 30.76632 -4.807292 1.454731 -2404.853 -669.8540 8.283054 8.282442 3.798592 3.803085 1.337182 1.397494 10.76721 15.11685 25.13368 -3.232585

t-statistics 1058.970 1348.547 156.3370 82.35968 -3.098604 1.430248 -3.763989 -1.217480 9966.584 9743.462 6552.790 4430.763 70.44161 85.80609 11.27193 19.42070 42.40087 -0.986330

HK 0.190638 -0.339144 IR -31.25034 2.010933 PP 28.51714 6.125479 RI 6487.714 1348.772 RMB -0.002537 -0.000620 RM 0.000648 -0.003786 SD 0.229156 0.047781 TB 17.34619 3.647948 TW 3.623325 23.64427

t-statistics 27.71496 -27.53139 -39.22242 37.54691 31.54412 42.00551 17.42603 17.09850 -5.945654 -5.087910 1.917931 -3.952905 20.71650 20.46250 31.16349 32.68811 11.90741 10.79750

Adjusted R2 0.849411 0.847700 0.918728 0.911961 0.879649 0.928401 0.689970 0.681766 0.201647 0.154685 0.019314 0.097098 0.758939 0.754386 0.877052 0.886997 0.508646 0.459429

FCEU FINE FINE FIRA FIAD FIRA FIAD FIRA FIBR FIRA FIAD FIJY FIAD FIRA FIAD FIRA FIBR FICD

The Cochrane-Orcutt estimates are not reported because the estimated value of is in almost all cases equal to 1. This suggests that a price change level model might be more appropriate. This is consistent with the large body of the literature on cross hedging currencies. The estimates for the hedge ratio are given in Table 9.

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Table 9. Cochrane-Orcutt estimates for cross hedging currency contracts

HKFCEU HKFINE IRFINE IRFIRA PPFIAD PPFIRA RIFIAD RIFIRA RMBFIBR RMBFIRA RMFIAD RMFIJY SDFIAD SDFIRA TBFIAD TBFIRA TWFIBR

1.00005 1.00004 0.99972 1.00076 1.00212 1.00007 1.00062 0.99982 0.99821 0.99974 1.00287 1.00064 0.99996 1.00003 1.00432 0.99735 1.00073

2 -0.01109 -0.00825 -3.66030 -0.05448 1.807282 -0.15319 1539.276 0.008297 4.878976 0.000673 -0.897467 -0.000521 0.235425 -0.576277 2.987897 0.846184 1.097803

t-statistics -1.42517 -0.51196 -2.27673 -0.36827 0.740944 -0.20692 1.583182 0.982653 2.007487 2.874534 -1.09789 -0.09767 -1.78678 -0.00786 -0.93434 1.867868 1.487897

Durbin-Watson statistics 2.600140 2.637038 2.223086 2.260041 2.441125 2.424785 1.779929 2.265767 2.534242 2.653865 2.389865 2.252586 2.145674 2.036357 2.367547 2.253453 2.554588

TWFICD

1.00123

-0.00056

1.98789

2.357545

The optimal hedge ratios are calculated as the beta coefficient of a significant futures contract. Although the calculations are tedious, involving a backward elimination model selection procedure starting from the multiple linear model with a portfolio of all futures contracts variables, only the results for the relevant pairs of spot and futures exchange rates are provided in Table 10 in next section. The last column of the table contains estimates calculated via a non-OLS method. The two sets of results can then be easily compared in terms of signs and order of magnitude.

4.3 Scholes-Williams estimates

Some of the problems that appear with regression models may be due to non-synchronisation between spot data and futures data. It is worth calculating then the optimal hedge ratios via an instrumental variable method (Scholes-Williams) as described in Section 3.3.

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Table 10. Price change estimates and SW estimates for cross hedging currencies
Variable significant FIBR FINE FNYF FIBR FIMX FIBR FIJY FIAD FINE FNZX t-stats for the beta -1.942124 -2.278052 2.096970 2.498447 1.940431 -2.957913 -2.918820 5.272407 -3.698060 1.316747 p-values for the beta 0.0542 0.0243 0.0379 0.0137 0.0544 0.0037 0.0041 0.0000 0.0003 0.0319 Beta-estimates -0.032779 -3.661866 5.365034 1033.397 0.132118 -0.003243 -0.181490 0.160678 -18.13703 2.855127 SW estimates 0.02139 -1.89491 0.59352 1823.241 0.04313 -0.00112 -0.06842 0.252747 -25.5885 5.32973

HKUS IRUS PPUS RIUS RMBUS RMUS SDUS TBUS TWUS

We have included variables having P-values very close to the significance level 0.05 because with another set of data the significance may change. One of the drawback of the Scholes-Williams estimator is that little is known about its properties. In an applied manner, the efficiency of both sets of estimates can be measured out of the sample. However the sets of data that we used shows signs of a structural break around September 2000 and some investigations based on the Chow test are currently in progress.

5. Conclusions

Risk management for a problematic commodity such as kerosene (jet fuel) is complicated when the base of the operations is an emerging country. The instruments available on the financial markets are not numerous and there is no clear-cut technique that will help the risk manager to hedge the cash flows involved in managing this commodity. It is impossible to organise a perfect hedge because kerosene futures are traded only on Tokyo and the reference point here is an emerging market country. Therefore the only thing that is achievable is to minimise the risk. In this paper we investigated some of the solutions that can be applied in practice based on current data. Two strategies were proposed. Firstly, one can try and cross-hedge the kerosene with futures contracts on crude oil, heating oil, gasoline. Secondly, one may decide to buy the futures on

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kerosene in Tokyo and hedge then the exchange rate to Japanese yen or other hard currency like U.S. dollar. The empirical evidence presented in this paper shows that, for emerging countries, the calculation of optimal hedge ratios based on regression based methods is questionable. The efficiency of hedging is not very high and the whole statistical estimation process may need a fresh approach where the OLS assumptions are not necessarily valid. The problems related to autocorrelation are corrected with a Cochrane-Orcutt estimation procedure but the fit of the new models to the data is not pleasing. Maybe the problem lies with the futures prices and poor synchronisation between spot data and futures data. An answer for this problem relies on the instrumental variable approach. The estimates are calculated easy but nothing can be said about the performance of this estimator.

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Appendix 1

Table A1. Correlations between Spot and Futures Prices

Table Spot and Futures Prices Correlations

FCEU HKUS IRUS PPUS RIUS RMBUS RMUS SDUS TBUS TWUS 0.92 0.90 0.87 0.64 -0.25 0.02 0.76 0.84 0.20 FIAD 0.83 0.94 0.94 0.83 -0.37 0.16 0.87 0.94 0.45 FIBP 0.84 0.95 0.92 0.78 -0.33 0.14 0.86 0.91 0.43 FIBR 0.50 0.69 0.75 0.67 -0.46 0.02 0.73 0.79 0.72 FICD 0.38 0.65 0.68 0.78 -0.39 0.31 0.72 0.73 0.68 FIDM 0.92 0.90 0.87 0.64 -0.25 0.02 0.76 0.84 0.21 FIFR 0.92 0.90 0.87 0.64 -0.25 0.02 0.76 0.84 0.21 FIJY 0.07 -0.27 -0.31 -0.54 0.19 -0.32 -0.59 -0.35 -0.80 FIMX 0.52 0.51 0.49 0.28 -0.13 -0.02 0.46 0.53 0.23 FINE -0.92 -0.96 -0.93 -0.72 0.32 -0.05 -0.78 -0.92 -0.28 FIRA 0.84 0.96 0.96 0.83 -0.40 0.18 0.87 0.94 0.51 FIRU -0.23 -0.18 -0.24 -0.25 -0.06 0.03 -0.21 -0.23 -0.08 FNYF 0.91 0.84 0.80 0.56 -0.21 -0.03 0.70 0.77 0.10 FNZX 0.44 0.46 0.45 0.30 -0.08 0.00 0.33 0.44 0.14

Table A2. ADF tests for random walk hypothesis

ADF FCEU FIAD FIBP FIBR FICD FIDM FIFR FIJY FIMX FINE FIRA FIRU -7.953150 -7.344890 -8.506203 -9.599300 -8.044370 -8.422368 -8.001995 -8.461334 -8.642969 -7.359875 -8.578433 -7.490564 FNYF FNZX HKUS IRUS PPUS RIUS RMBUS RMUS SDUS TBUS TWUS ADF -7.802790 -7.346365 -11.68428 -8.119069 -8.472214 -7.267894 -7.807324 -5.179745 -7.229745 -8.325468 -6.928866 Critical Values 1% 5% 10% 134obs -2.5810 -1.9423 -1.6170

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Table A3. ADF tests for cointegration, with the regressand variable under the Futures column

Futures
FCEU FINE FINE FIRA FIAD FIRA FIAD FIRA FIBR FIRA

ADF
Hong Kong -2.548160 -2.363381 IRUS -2.692138 -2.564823 Philippines -2.891567 -2.901785 RIUS -2.505554 -1.951939 China -6.437518 -6.139744

Futures
FIAD FIJY FIAD FIRA FIAD FIRA FIBR FICD

ADF
Malaysia -7.122474 -8.389120 Singapore -2.686329 -2.690358 Thailand -2.503748 -2.356806 Taiwan -2.507233 -1.859965

Level of significance
1% 5% 10%

Critical value
-2.5809 -1.9422 -1.6169

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