Hedging the price risk of local commodities on international futures

markets: optimal hedge ratios and risk reduction

By
Rutger Jan Flohil∗
Student number 0331074
January 2009

First supervisor: Dr. L. Zou

Second supervisor: Dr. L. Phalippou

ABSTRACT

In this study it is investigated to what extent the producers (agriculturists), users (industrials) and traders of
commodities who are holding positions in local commodity cash markets can decrease their portfolio risk by
creating a cross-hedge in a related futures market. It is examined how to derive the optimal hedge ratio that
minimizes the variance of the portfolio return, the minimum variance hedge ratio (MVHR). A data set,
consisting of weekly prices of 9 local commodity markets and their corresponding related futures prices, is
used in the empirical research. Hedge ratios are derived from different models based on in-sample
observations and are tested for post-sample forecasts to determine their effectiveness. The results indicate
that the traditional OLS model outperforms both the ECM model and the conditional GARCH-based models
in deriving the MVHR. For 6 out of the 9 different tested local commodity markets the variance of the
portfolio return is reduced between 37% and 16% by the creation of a hedge in a related (foreign) futures
market.

Keywords: minimum variance hedge ratio, commodities, hedging, futures, risk

∗
E-mail: rutgerjan.flohil@uva.nl or rutger.flohil@cems.org
Faculty of Economics and Business Administration
Universiteit van Amsterdam ● Roetersstraat 11, 1018 WB Amsterdam, the Netherlands
Content

Executive summary .................................................................................................................... 3

I. Introduction ............................................................................................................................ 5
II. The Minimum Variance Hedge Ratio.................................................................................. 7
The traditional method ..................................................................................................................... 9
The error correction method ............................................................................................................ 9
The ARCH-based method............................................................................................................... 10
Review on empirical results on the MVHR................................................................................... 13
III. Quantifying the risk of the portfolio................................................................................. 16
IV. Data Description ................................................................................................................ 18
V. Methodology ........................................................................................................................ 19
VI. Empirical Results............................................................................................................... 21
VII. Implications and recommendations for further research .............................................. 26
VIII. Conclusions .................................................................................................................... 30
References ................................................................................................................................ 31
Appendix .................................................................................................................................. 34

Table I……………………………………………………………………………………….. 15
Table II……………………………………………………………………………………… 18
Table III……………………………………………………………………………………... 21
Table IV……………………………………………………………………………………... 22
Table V………………………………………………………………………………………..24
Table VI……………………………………………………………………………………... 24
Table VII……………………………………………………………………………………. 25
Table VIII………………………………………………………………………………….... 25
Table IX……………………………………………………………………………………... 34
Table X……………………………………………………………………………………… 34
Table XI…………………………………………………………………………………….. 37
Table XII……………………………………………………………………………………. 37
Table XIII………………………………………………………………………………….... 38
Table XIV…………………………………………………………………………………… 39
Table XV…………………………………………………………………………………….. 39
Table XVI…………………………………………………………………………………… 41

Figure I…………………………………………………………………………………… . 43
Figure II…………………………………………………………………………………… 45
Executive summary

In the last few years we have seen an increase in the volatility of many commodity markets.
Especially the year 2008 has shown unprecedented swings in commodity prices. The
increasing volatility causes excessive fluctuations in earnings of the producers (agriculturists),
users (industrials) and traders who are holding positions in these cash commodity markets. In
this study it is examined how to derive the hedge ratio that minimizes the variance of the
portfolio return, the so-called minimum variance hedge portfolio (MVHR). The determination
of the MVHR has been one of the main topics within this field of research and nowadays, there
still is no general consensus among researchers on how to compute the MVHR. In addition, it
is investigated to what extent companies who are holding positions in local commodity cash
markets can decrease risk by creating a cross-hedge in a related futures market.
In this study the different methods to compute the MVHR are tested on a dataset
consisting of weekly prices on 9 local European commodity cash markets and their
corresponding related futures. The first examined approach to compute the hedge ratio is the
OLS method, which estimates the hedge ratio as the OLS coefficient of a regression of cash
price return on futures return. The second approach takes into account the long-term
equilibrium between cash prices and futures prices. In case cash prices and futures prices are
cointegrated, than the traditional price change regression should be modified taken into
account an error correction term. The third approach believes that the MVHR is varying over
time. In this thesis three different ARCH-based techniques will be applied to determine a
dynamic time-varying MVHR: the Constant Correlation GARCH (CC-GARCH), the diagonal
BEKK and the diagonal VECH model. The MVHR as derived from different models based on
in-sample observations has been tested for post-sample forecasts to determine its effectiveness.
The mean squared error and the variance of returns are used to measure the risk of the different
portfolios that have been constructed using the computed hedge ratios. I have compared these
portfolios with the portfolio which consists of only the cash position without any hedge in the
futures market.
The results indicate that in 5 out of the 9 investigated markets the hedge ratio as
derived from the OLS model performs best. In 2 other markets the variance of portfolio return
is only slightly worse than the portfolio return using hedge ratios computed by other models. It
is found that the examined weekly return series are cointegrated and appear to exhibit time-
varying conditional heteroscedasticity. However, no evidence is found that the ECM model or
the conditional GARCH-based model compute consistently a better performing MVHR in the
tested markets than the traditional OLS model. Although the results found in this study are in
line with research of Lien (2002), Bystrom (2003) and Harris (2007), they do contradict with
many other scholars. It should be noted that the setting of this study differs from other
investigations, since in this study the hedge ratios are tested by cross-hedging the commodity
instead of hedging the underlying of the futures market against its nearest futures contract. The
construction of a hedge in a highly correlated futures market reduces the variance of returns
significantly in 8 out of the 9 markets. For 6 out of the 9 different tested local commodity
markets the variance of the portfolio return is reduced between 37% and 16% by the creation
of a hedge in a related (foreign) futures market. It was found that the extent to which the local
commodity market returns and the futures returns are related, does affect the degree of risk
reduction from the cross-hedged portfolio.
I. Introduction

In the last few years we have seen an increase in the volatility of many commodity markets.
Especially the year 2008 has shown unprecedented swings in commodity prices. The
increasing volatility causes excessive fluctuations in earnings of the producers (agriculturists),
users (industrials) and traders who are holding positions in these cash commodity markets. All
parties holding positions in these cash commodity markets are now exposed to more and more
risk. Fortunately, taking positions at the futures exchange can nowadays mitigate part of the
risk. Because cash and futures prices for the same commodity tend to move together, the
changes in the value of a cash position are offset by changes in the value of an opposite futures
position. An unhedged trader faces the price risk of the asset in the cash market. The hedged
trader faces basis risk, the risk caused by difference between the price in the cash market and
the price in the futures market. As long as the basis risk is smaller that the price risk, producers
and users can make use of hedging to further stabilize their earnings. Producers will hedge
their revenues long before they will actually harvest their crops. Users can assure the quantity
and price of the crops they will use as inputs for their production before the crops are actually
harvested. (Hull, 2005)
Cash and futures price movements are not perfectly correlated. For this reason risk
management requires determination of the “optimal hedge ratio”, which is the ratio of the
value of futures contracts purchased or sold to the value of the cash commodity being hedged.
(Hull, 2003). The optimal hedge ratio is the combination of cash and futures position that
maximizes the utility of the trader. Baillie and Myers (1989) show that, provided expected
returns to holding futures are zero, the utility maximizing hedge is the hedge that minimizes
the variance of the portfolio. The hedge that minimizes the variance of the portfolio is called
the minimum variance hedge portfolio (MVHR). To implement an effective hedge it is
important to calculate this MVHR. The determination of the MVHR has been one of the main
topics within this field of research.
Traditionally three different approaches have been proposed to compute the ratio that
minimizes the variance of the hedged portfolio. First, there is the approach of the traditional
hedge. The traditional hedger believes the hedge ratio is constant over time. There is the naïve
or one-to-one hedge, which sets the hedge ratio equal to one over the period of the hedge. In
addition there is the static Ordinary Least Squares (OLS) hedge, which estimates the hedge
ratio as the OLS coefficient of a regression of cash price return on futures return (Ederington,
1979). The second approach takes into account the long-term equilibrium between cash prices
and futures prices. Engle and Granger (1987) show that if two series are nonstationary but a
linear combination of them is stationary, the two series are cointegrated. If the cash prices and
futures prices are indeed cointegrated, than the traditional price change regression should be
modified, taken into account an error correction term. According to the third approach the
MVHR is varying over time. Many models have been proposed which allow for serial
correlation and time varying distributions in financial time series. In this study three different
ARCH-based techniques will be applied to determine a dynamic time-varying MVHR. The
Constant Correlation GARCH (CC-GARCH) model, as specified by Bollerslev (1990), takes
into account time-varying variance of both the futures returns and the return on cash prices.
The correlation in this model is however constant over time. The diagonal BEKK model, as
proposed by Kroner and Sultan (1993) and Engle and Kroner (1995), allows for varying
variance of returns as well as a varying correlation between returns in time. The diagonal
VECH model of Bollerslev, Engle and Wooldridge (1988) does also take into consideration
both a varying variance as well as a varying correlation.
In this field of research the MVHR are being computed based on “within the sample”
observations. Next, “out of the sample” forecasting to measure the variance of the returns will
be performed to find out which model provides the most effective hedge ratio. Many studies
have investigated different models at different markets. But at the moment there is no general
consensus about which technique should be used to calculate the MVHR (Harris et al., 2007).
Furthermore, research has been focused on finding the MVHR when the cash market is the
underlying of the futures markets. But most local commodity markets do not have a futures
market. Most hedges are created on related futures contracts with a different underlying; this is
a so-called cross hedge.
In my thesis I would like to offer a contribution to this question by applying various
models to determine the MVHR for products traded on local European commodity cash market
while hedging the position with a related commodity futures contract. As far as I know nobody
has ever evaluated the different methods to determine the MVHR in this setting. In this study I
will furthermore quantify the possible decrease of risks which producers, users and traders of
commodities who are holding positions in these cash markets are exposed to. The mean
squared error and the variance of returns is used to measure the risk of the portfolios.

The remainder of the paper is organised as follows. Section II reviews the relevant literature
and theory on the different models for calculating the optimal hedge ratio. An overview of the
results of the empirical studies will be presented. Section III is concerned with the methods to
quantify the risk of a portfolio. Section IV introduces the data set that will be used for the
empirical investigation. The details of the used methodology are presented in section V. In
section VI the results of the empirical research are reported in more detail. The implications of
this study and the recommendations for further research will be given in section VII. Finally,
the conclusion of this study will be presented in section VIII.

II. The Minimum Variance Hedge Ratio

Producers, industrials and traders of commodities who are holding positions in commodity
cash markets will try to mitigate the risk caused by price swings in the cash market by taking
opposite positions in a highly correlated futures market. The value change of the futures
position will largely offset the value change in the cash market. The trader will have to
determine how many futures contracts to buy or sell to offset the value change of its position in
the cash market caused by the price fluctuations. The amount of futures contracts purchased or
sold as a fraction of the quantity of the cash commodity being hedged is called the hedge ratio.
If the expected return to holding futures is zero, the hedge ratio that maximizes the utility of
the trader is the ratio that minimizes the variance of the return of the portfolio. This implies
that the so-called optimal hedge ratio is equal to the minimum variance hedge ratio (Baillie and
Myers, 1989).
According to Ederington (1979) and Figlewski (1984) the return at time t on the
portfolio can be expressed as:

( Pt − Pt −1 ) = Qs ( St − St −1 ) - Qf ( Ft − Ft −1 ) (1)

Where:
Pt ≡ value of the portfolio at time t and

Pt−1 ≡ value of the hedged portfolio at time t - 1

Q s ≡ quantity of the cash position

Qf ≡quantity of the futures position

St ≡ cash price at time t

S t−1 ≡ cash price at time t – 1

Ft ≡ futures price at time t

Ft−1 ≡ futures price at time t - 1

Qf
The hedge ratio h is equal to
Qs
The return of the hedge portfolio at time t can also be written as:

Rp = R s - h Rf (2)

Where:
R p ≡ return on portfolio ( Pt − Pt −1 )

RS ≡ return on cash (S t − S t −1 )

R f ≡ return on futures ( Ft − Ft −1 )

The variance of the returns on the hedged portfolio, conditional upon information set Ω
available at time t-1 equals:

σ 2 ( R p ΙΩ t −1 ) = σ 2 ( Rs ΙΩ t −1 ) + (hΙΩ t −1 )σ 2 ( R f ΙΩ t −1 ) − 2(hΙΩ t −1 )σ ( Rs , R f ΙΩ t −1 ) (3)

To minimize the variance of the portfolio we set the first derivative of σ 2 ( R p ΙΩ t −1 ) with

respect to (hΙΩ t −1 ) equal to zero. The minimal variance hedge ratio h* can than be calculated
with the following formula:

σ ( Rs , R f ΙΩ t −1 )
(h * ΙΩ t −1 ) = (4)
σ 2 ( R f ΙΩ t −1 )

In the equation σ ( Rs , R f ΙΩ t −1 ) is the conditional covariance between the cash return and the

futures returns upon information set Ω available at time t-1 and σ 2 ( R f ΙΩ t −1 ) is the

conditional variance of the futures returns upon information set Ω available at time t-1.
To implement an effective hedge it is important to calculate the MVHR. Unfortunately,
we cannot measure the conditional variance and covariance at time t-1. The determination of
the MVHR has been one of the main topics within this field of research.
The traditional method

Assuming that the correlation between the futures market and the cash market is at all times
perfect, a trader should place a hedge in the futures market for the same quantity as he has
positions in the cash market. This naïve or one-to-one hedge can be seen as the lowest
benchmark for the MVHR estimation.
Traditionally, the MVHR is calculated using historical data by regressing the cash
returns on the futures returns.

Rs = α + h Rf + ut u t ~ i.i.d .(0, σ 2 ) (5)

The slope coefficient h of this ordinary least squares (OLS) regression is the appropriate hedge
ratio that historically minimizes the variance of returns. Both the naïve hedges as well as the
OLS hedge are a static hedge, which means that the hedge ratio is constant over time and that
the hedger makes no use of publicly available information while forming expectations of
futures hedge ratios. (Ederington, 1979) and (Anderson and Danthine, 1980)

The error correction method

The error correction approach takes into account the long-term relation between cash prices
and futures prices. A series is said to be stationary if the mean and autocovariance of the series
does not depend on time. The theory developed by Engle and Granger (1987) shows that if two
series are non-stationary but a linear combination of them is stationary, the two series are
cointegrated. Cointegration conjoins the long-run relation between the two financial time
series. When cash prices and futures prices are indeed cointegrated, than the traditional price
change regression should be modified, taken into account an error correction term. This means
that the regression given by equation (5) is not longer correct, because it omits an error
correction term. The error correction model (ECM) abstracts short- and long-run information
in modeling the data. (Kroner and Sultan, 1993)
Ghosh and Clayton (1996) who applied the cointegration to hedging, used the
following regression with an error correction model.
 m n
Rs = α + αet −1 + h Rf + ∑ Θ i R f −i + ∑ Φ j Rs − j +u t (6)
i =1 j =1

Where the number of legs n and m has to be large enough to make ut white noise and h is the
optimal hedge ratio. In this equation the return in the cash market is not only a function of the
return in the futures market, but also a function of past equilibrium errors and lagged values of
the changes in both cash and futures prices.

The ARCH-based method

The OLS regression assumes that error term (u t ) is white noise with zero mean, constant
variance and no autocorrelation. Since some time periods can be more riskful than other
periods, the variance of the error terms in financial time series may be expected to be larger for
some ranges in data than for others. Moreover, these risky times are not scattered randomly,
but there is a degree of autocorrelation in the risk of financial returns. Data of which the
variance of the error terms is not equal are said to suffer from heteroscedasticity. In the
presence of heteroskedasiticy the ordinary least squares regression may give a false sense of
precision. ARCH and GARCH models, which stand for autoregressive conditional
heteroscedasticity and generalized autoregressive conditional heteroscedasticity, however do
treat heteroscedasticity as a variance to be modelled and are designed to deal with just this set
of issues. (Engle and Sheppard, 2001)
ARCH models were introduced by Engle (1982) and generalized as GARCH by
Bollerslev (1986). The GARCH (1, 1) model is expressed:

Yt = X t ' Θ + ut (7)

Where Yt is written as a function of exogenous variables with an error term.

σ 2 t = ω + αu t2−1 + σ 2 t −1 (8)

Where σ 2 t is called the conditional variance, the one period ahead forecast variance based on
past information. ω is a constant term, news about volatility of the previous period is
measured with ut2−1 (the ARCH term) and the last period’s forecast variance is σ 2 t −1 (the
GARCH term).
Constancy of the hedge ratio restricts the variances of commodity cash prices and
commodity futures prices and the covariance between them to be constant. However, since it is
well known in the finance literature that asset returns typically exhibit time-varying volatility,
we can use ARCH and GARCH models to compute conditional variances of returns and a
conditional covariance between returns. With time-varying conditional variances and
conditional covariance it is possible to estimate a dynamic hedge ratio.
Bollerslev (1990) proposed the constant correlation GARCH (CC GARCH) to compute
a dynamic MVHR. We could calculate the MVHR by using equation (4). The conditional
covariance can be specified by the equation:

σ ( Rs , R f ΙΩ t −1 ) = ρ * σ ( Rs ΙΩ t −1 )σ ( R f ΙΩ t −1 ) (9)

Where ρ is the conditional correlation between the cash returns and the futures returns,

σ ( Rs ΙΩ t −1 ) is the conditional deviation of the cash returns and σ ( R f ΙΩ t −1 ) is the conditional

deviation of the futures returns. The conditional variance of the cash returns σ 2 ( Rs ΙΩ t −1 ) and

the futures returns σ 2 ( R f ΙΩ t −1 ) can be found using the following univariate GARCH

equations:

σ 2 ( Rs ΙΩ t −1 ) = c1 + α 1u t2−1 + β1σ 2 t −1 ( Rs ΙΩ t −2 ) (10)

σ 2 ( R f ΙΩ t −1 ) = c 2 + α 2 u t2−1 + β 2σ 2 t −1 ( R f ΙΩ t −2 ) (11)

Bollerslev assumed that the conditional correlation ρ is constant over time and can be
estimated as the sample correlation coefficient between the cash and futures returns. The
dynamic MV hedge ratio can therefore now be estimated by the ratio of two time-varying
conditional standard deviations multiplied by a constant conditional correlation ρ . In order to
compute this model, 7 parameters have to be calculated. (Bera and Kim, 2002)

Uni-variate GARCH models can obtain the conditional variances, but to obtain estimates for a
time-varying conditional covariance, we need to use a multivariate GARCH model. Bollerslev,
Engle and Wooldridge (1988) have shown that the uni-variate GARCH model can be
generalized to a multi-variate setting. The so-called VECH model can be written as:

vech( H t ) = vech(c) + Avech(ε t −1ε 't −1 ) + Bvech( H t −1 ) (12)

Or

 H 11,t  c01   a11 a13  ε 1,t −1  g g 13   H 11,t −1 

2
a12 g 12
       11  
H t =  H 12,t  = c02  + a 21 a 22 
a 23  ε 1,t −1ε 2,t −1  +  g 21 g 22 g 23   H 12,t −1  (13)
 H  C  a
 22,t   03   31 a 32 a 33  ε 2  g g 32 g 33   H 22,t −1 
 2,t −1   31
Where H t is the conditional covariance matrix and vech is the operator which stacks de
columns of the lower triangle of a N x N symmetric matrix as an N (N+1)/2x1 vector. The
vector ε t denotes the error terms at time t, the vector c has dimension N (N+1)/2x1 and
matrices A and B have dimension N (N+1)/2xN(N+1)/2. This model is an extension of the uni-
variate GARCH model that is easy to understand. Unfortunately, the number of parameters to
be estimated in the GARCH equation increases rapidly with O (n^4), which limits the number
of assets that can be included. Furthermore, it is required that conditional covariance ( H t )
matrix is positive definite for all values. To reduce the number of parameters to be estimated,
Bollerslev, Engle and Wooldridge assume that the matrices A and B are diagonal. For this
reason the elements of H t only depend on their own past and the respective elements of

ε t −1ε 't −1 and the number of parameters reduces to O (n^2). The restricted VECH or diagonal
VECH model can now be written as:

 H 11,t  c01  a11 0  ε 1,t −1  g 0   H 11,t −1 

2
0 0
       11  
H t =  H 12,t  = c02  +  0 a 22 
0  ε 1,t −1ε 2,t −1  +  0 g 22 0   H 12,t −1  (14)
 H  C   0
 22,t   03   0 a 33  ε 2  0
  0 g 33   H 22,t −1 
 2,t −1

The restriction that matrices A and B are diagonal, seems plausible, since information about
covariance is usually revealed in squared residuals, and if the covariance is evolving slowly,
then passed squared residuals should be able to forecast futures covariance (Engle, Kenneth
and Kroner, 1995). Imposing this restriction on A and B, the conditional covariance can be
written as:

σ ( Rs , R f ΙΩ t ) = c sf + β sf σ sf ,t −1 + α sf ε s ,t −1ε f ,t −1 (15)
The time-varying conditional covariance σ ( Rs , R f ΙΩ t ) depends solely on past own cross

products of residuals. In order to determine the conditional variances of both cash and futures
prices and the conditional covariance, the diagonal VECH model estimates 9 parameters. The
main problem of the diagonal VECH model parameterization is that it is really hard to impose
the restriction of positive indefiniteness. Engle and Kroner (1995) proposed a new model that
guaranties the positive indefiniteness of the conditional covariance in the VECH model. This
restricted version of the VECH model is the Baba-Engle-Kraft-Kroner (BEKK) model.

H t = C ' C + A' ε t −1ε 't −1 A + B' H t −1 B (16)

Where C is the upper triangular matrix, A and B are N x N parameter matrices. Non-negativity
restrictions on parameters C, A and B assure that one always obtains a positive definite matrix
H t . Compared to the diagonal model, the BEKK-specification economizes on the number of
parameters by restricting the VECH model within and across equations. For the empirical
work, the BEKK model will be preferable, because it is much easier to estimate while being at
the same time sufficiently general. In order to determine the conditional variances of both cash
and futures prices and the conditional covariance, the BEKK model estimates only 5 different
parameters.

Review on empirical results on the MVHR

A substantial amount of empirical research on the calculation of the MVHR has been done
over the last decades. The naïve hedge has always been criticised for assuming that the
correlation between the futures and the cash market is at all times perfect. The OLS does not
take into account time-varying variances and serial correlation of time series nor cointegration
between time series.
Different researchers have found that returns of futures and cash prices are
cointegrated and that hedge ratios based on ECM models perform better than hedge ratios
based on OLS regression. Chou, Fan Denis and Lee (1996) compare the hedge ratios of the
conventional and the ECM models using the Nikkei Stock Average index and the futures on
the index. Comparisons of post-sample hedging performance reveal that the ECM hedge
ratios reduce variance of returns of about 2% compared to the OLS hedge. Lien (1996) finds
that by omitting the cointegration relationship, one will adopt a smaller than optimum futures
position, which results in a relatively poor hedge performance due to misspecification of spot
and futures prices. Ghosh and Clayton (1996) use likelihood ratio tests and post-sample
forecasts to show that the hedge ratio as derived from the ECM is superior to the one obtained
from the OLS model. Lien and Shrestha (2008) examine twenty-four commodity and
financial futures markets to compare the hedging effectiveness of the naïve hedge, the OLS
hedge and the ECM hedge. The OLS hedge outperforms the naïve hedge in fifteen out of the
twenty-four markets. The OLS hedge performs better than the ECM hedge in only nine
markets.
ARCH-based models allow for time varying variance and serial correlation of the
returns of futures and cash prices. Baillie and Myers (1991) conclude after having examined
post-sample variances of six different commodities, that a time-varying conditional hedge ratio
derived from a GARCH (1,1) model performs better than a constant OLS hedge ratio. They
find that the percentage of variance reduction with the hedged portfolio, compared with no
hedging, ranges from 7% till 52%. Rossi and Zucca (2002) also found GARCH-based hedge
ratios to perform better than OLS-based hedge ratio on different LIFFE traded futures. The
studies of Park and Switzer (1995) and Lien (2002) have also concluded that the ARCH-based
models for determining the MVHR provide better performance than OLS regressions.
Other researchers have compared the effectiveness of the hedge ratios derived from the
OLS, the ECM and GARCH models in one study. Kroner and Sultan (1993) find that return
distributions are time varying and that asset prices are indeed cointegrated. This study
compares the hedging effectiveness of a time-varying GARCH (1,1) hedge ratio and an ECM
hedge ratio with the conventional OLS hedge ratio and the naïve hedge ratio in foreign
currency futures. For four out of the five tested markets, the post-sample return variance
comparisons indicate that the time-varying GARCH model outperforms all the other models up
to 4%. The study of Floras ad Vougas (2004) on hedge ratios on the Greek stock and futures
market found that ECM model and GARCH models performed better than the OLS model.
However, in the literature evidence is found that hedge ratios derived from both the
time-varying conditional models as well as from ECM models, do not always perform better
than hedge ratios derived from the traditional models. Harris (2007), who evaluated the post-
sample performance of the hedge of three currencies where hedge ratios where based on both
conditional MVHR (ARCH-based) and unconditional MVHR (OLS-based), finds a poor
performance of conditional MVHR models relative to the unconditional MVHR model.
Studying ten spot and futures markets covering currency futures, commodity futures and stock
index returns, Lien (2002) does also find evidence that the OLS hedge performs better that
ARCH-based hedge. Bystrom (2003) concludes in his study on the hedging effectiveness in the
electricity futures in Norway that the OLS hedge ratio performs slightly better than conditional
ARCH-based hedge ratios. An overview the most important scholars in this field of research
and their findings can be found in table 1.

Table I

The table provides an overview of the most important empirical studies on MVHR models and their
corresponding findings.
Author Investigation Findings

1. Kroner and Compare ECM with regression and Cointergration exists. OHR with ECM superior
Sultan naïve hedge on five different within sample and out of sample.
(1993) currencies.

2. Park and Investigate MVHR for S&P 500 index Find that GARCH based hedge ratios vary over time
Switzer futures, MMI futures and Toronto 35 and show that GARCH based models perform better
(1995) index futures that the OLS model.

3. Gosh and Apply the theory of cointegration to Cointergration exists. OHR with ECM superior in
Clayton hedging with stock index futures (CAC out of sample.
(1996) 40, FTSE 100, DAX and NIKKEI).

4. Lien (1996) Compare ECM with regression in a Cointergration does exist. Hedging without taking
theoretical analysis. into account the cointegration will lead to under
hedging.

5. Lien (2002) The authors examine ten spot and OLS hedge ratio performs slightly better than
futures markets covering currency conditional ARCH-based hedge ratios.
futures, commodity futures and stock
index

6. Bystrom Examine the hedging effectiveness in OLS hedge ratio performs slightly better than
(2003) the electricity futures in Norway conditional ARCH-based hedge ratios.

7. Rossi and Examine hedge ratios on different GARCH-based hedge ratios are performing better
Zucca LIFFE traded futures than OLS-based hedge ratio
(2002)

8. Floras and Study hedge ratios on the Greek stock ECM model and GARCH models perform better
Vougas and futures market than the OLS model.
(2004)

9. Harris Evaluates the in-sample performance Finds a poor performance of conditional MVHR
(2007) of the cross-hedge of three currencies models relative to the unconditional MVHR model.

Lien and Examine twenty-four commodity and The OLS hedge outperforms the naïve hedge in
10. Shrestha financial futures markets to compare fifteen out of the twenty-four markets. The OLS
(2008) the hedging effectiveness hedge performs better than the EC hedge in only
nine markets.
From this literature review it is not clear which model provides us the optimal hedge ratio to
offset adverse price movements in local commodity markets. Although researchers have
proposed different GARCH-based models, not one scholar has compared the effectiveness of
hedge ratios derived from the different GARCH models.

III. Quantifying the risk of the portfolio

An unhedged trader in commodities faces the risk that the price in the cash market will change.
A hedged trader, who is holding positions in the futures market, only faces risks by changes in
the basis. The basis is the difference between the cash price of a given commodity and the
price of the nearest futures contract for the same commodity. The level of predictability and
the size of the basis are dependent on the difference between the futures contract and the spot
price of the underlying commodity. The non-arbitrage formula should be:

Ft ,T = S t e r (T −t ) (17)

Where Ft ,T is the futures price of the commodity with maturity T, S t is the spot price and r is

the continuously compounded interest rate for one year. This relationship does not hold in
most commodity markets. An adjustment, the convenience yield, is made because of trading
constraints in the market. The convenience yield exists due to changes over time in availability
of stocks and inventories of the commodity in question. Our non-arbitrage formula than
becomes:

Ft ,T = S t e ( r −c )(T −t ) (18)

Where c is the convenience yield that reflects the market’s expectations concerning the futures
availability of the commodity.

In this study I will focus on products traded on local commodity cash market, which do not
have a futures market. The cash market prices have to be hedged on a related commodity
futures contract. The act of hedging ones position by taking an offsetting position in another
good with similar price movements are called cross hedges. However, in cross hedging many
other factors also influence the basis risk. By cross hedging commodities, the changes in local
supply-and-demand, transportation costs, storage costs, futures prospects of production and
prices and the local prices of substitutes that vary over time will influence the basis. As long as
the basis risk is smaller than the cash market risk, the trader can increase utility by hedging his
cash positions on a related futures market. In order to assure that the basis risk is smaller than
the local cash price risk, it is imperative that the futures market is strongly related to the local
commodity market (Hull, 2005).
This relatedness between cash market prices and futures prices can be determined by
measuring the correlation ( ρ )1 between the two commodity spot market prices or the returns
on the local commodity and the nearest futures. If the futures market is denominated in a
foreign currency, the trader is also facing currency risk. In this study I will quantify the
possible decrease of risk to which producers, users and traders of commodities who are
holding positions in cash markets are exposed. The MVHR as derived from the different
models (based on the in-sample observations), will be applied on post-sample portfolios to
determine its effectiveness. The risk of these portfolios can be quantified using the traditional
method of the variance ( σ 2 ) of the returns.

∑ (R p ,t − Rp )2
σ2= i =1
(19)
(T − 1)

Where R p,t is the return on the portfolio at time t and R p is the average return over the sample

period.
Following Novak and Unterschultz (1996) and Ghosh and Clayton (1996), we also
measure the change in risk using the mean squared error (MSE) method. The MSE measures
the root-squared deviation of the realized net price from the forecast price. We use the MSE in
the following setting:

∑ (R
i =1
s ,ti − R f ,ti ) 2
MSE = (20)
T −1
The closer MSE is to zero the better the futures hedge R f is offsetting changes in local

commodity cash returns Rs and hence the lower the variance of the portfolio.

IV. Data Description

The data on weekly commodity cash prices used in this paper were obtained from the
DataStream database and the database of the Local Catalan government. These markets are not
the underlying of a futures market and therefore the cash markets were matched with a highly
correlated future market. The data on futures prices were obtained from the Sitagri ADO
research data tool2. The corresponding weekly cash and future prices are examined during the
period from the beginning of January 2003 till the end of December 2008. Future contracts are
rolled over to the next nearby contract that includes the expiration month. The future price of
the nearby contract has been chosen because it is a highly liquid and the most active contract at
that moment. The prices of future which are denominated in a currency that differs from the
currency of the local commodity market have been adjusted, using the prevailing exchange rate
between the two currencies at that moment. The futures contracts prices have furthermore been
adjusted in a way that the future price represents the same quantity as that of the price in the
local market. The data is checked to ensure that the pairs of cash and future prices exactly
match every week. Table II provides an overview of the 9 examined cash markets and their
corresponding future markets.
Table II

This table shows an overview of the examined data in this study. The sample contains weekly commodity prices
and futures prices of the period January 2003 till December 2008. In total 9 commodity cash markets and their
corresponding futures markets have been examined. The sample can be divided in in-sample and post-sample
observations. The correlations between prices and returns for the entire sample have been calculated.

In- Post- Correlation Correlation

Commodity Cash market3 Futures market4 Observations sample sample prices returns
1 Soyoil Rotterdam (rot) CBOT 312 240 72 0.974 0.58
2 Soymeal Barcelona (bcn) CBOT 312 240 72 0.971 0.34
3 UK (uk) CBOT 312 240 72 0.971 0.344
4 Hamburg (ham) CBOT 312 240 72 0.946 0.542

1
Cov( S , F )
ρ S ,F = Where S are the cash prices, F are the futures prices Cov ( S , F ) is the covariance
σ S ×σ F
between S and F and σ is the standard deviation for the sample.
2
Sitagri is a research company that provides information for commodity traders
3
A specification of the cash markets can be found in the Appendix table IX
4
A specification of the futures contracts can be found in the Appendix table X
 5 Rotterdam (rot) CBOT 312 240 72 0.933 0.265
6 Corn Barcelona (bcn) Euronext 312 240 72 0.969 0.55
7 Lleida (llei) Euronext 312 240 72 0.97 0.467
8 Milling wheat Barcelona (bcn) Euronext 312 240 72 0.977 0.302
9 Lleida (llei) Euronext 312 240 72 0.979 0.356

The total sample of 312 observations is divided in an initial in-sample portion of 240
observations for estimations of the MVHR. The remaining 72 observations are used for post-
sample forecasting.

V. Methodology

In the following section the statistical analysis and the statistical procedures applied in this
study will be explained. First, the MVHR as derived from the models have been computed
based on the in-sample observations. In order to determine the traditional hedge ratio we have
made an OLS regression based on 240 in-sample observations. Using the weekly returns of
futures prices ( Ft − Ft −1 ) as independent variable and the weekly returns of cash prices

(S t − S t −1 ) as the dependent variable, we compute the optimal hedge ratio according to formula
(5).
For the error correction model approach, the cash and futures prices will first be tested
for cointegration. To be consistent with the assumption that prices follow lognormal
distribution, the natural logarithms of the prices will be examined. The series are checked for
unit root (non-stationarity) by performing both the augmented Dickey-Fuller (ADF) (1981)5
regression as well as the Phillips and Perron (PP) (1988)6 test. Once the tests show that each of
the series contain a unit root (indicates non-stationary), the series will be tested for
cointegration. Constructing test statistics from the residuals of the following regression checks
the existence of cointegration:

log Ct = a + b log Ft + ε t (19)

p
5
Written as ∆y t = α 0 + α 1 y t −1 + ∑ α i y t −1 + ε t where p is large enough to ensure that the residual series
i =1

εt is white noise.
6
Depicted by the formula: yt = b0 + b1 yt −1 + u t (where ut is white noise)
If the two series of cash prices ( Ct ) and futures prices ( Ft ) are cointegrated, ε t will be unit

root. Both the ADF test and the PP test will be performed on the residuals ε t . Cointegration
implies that an error correction representation exists in the series. In case cointegration
between the series is indeed confirmed, the ECM model of Ghosh and Clayton (1996) as
depicted in formula (6) will be applied to estimate the hedge ratio.
For the computation of the GARCH models, the natural logarithmic returns of the
relevant prices will be analysed. The returns on the cash and futures are defined as a
percentage change of each price7. First the several preliminary diagnostic tests on the return
series are performed. The Jarque Bera test8 statistic is applied to verify whether the series are
normally distributed. The Ljung-Box Q9 statistic is used to determine the existence of
autocorrelation in the series. In this study we will test three different GARCH models: the CC-
GARCH, the Diagonal VECH and the BEKK model. The parameters of these models will be
calculated using the Eviews 6 statistical program. The CC-GARCH model will be build as
described by equations (10) and (11). The Diagonal VECH parameters will be determined
using the formula (12) model while taking into account the appropriate restrictions. The BEKK
variance and covariance equations will be calculated using the method described in the
formula (14). All parameters of the different GARCH-based models are estimated using the
maximum likelihood method of the Berndt, Hall and Hausman (1974) algorithm10. The time-
varying conditional MVHR can be constructed using the following formula:
hsf ,t
(b *t ) = (21)
h ff ,t

Where h ff ,t is the computed conditional variance of the futures series, hsf ,t is the conditional

covariance and (b *t ) is the MVHR at time t .

In order to compare the performance of each MVHR method, we construct the portfolios
implied by the computed hedge ratios and calculate the variance of the returns on these

7
Rts = log ( S t / S t −1 ) and Rtf = log ( Ft / Ft −1 )
N  2 ( K − 3) 2 
8
J-B =  S +  where S is the skewness and K is the kurtosis
6 4 
k τ 2j
9
Q = T (T + 2)∑ Where τj is the J -th autocorrelation and T is the number of observations.
j =1 T−J
portfolios over both the in-sample and the post-sample observations. The variance of the
returns of the corresponding hedge portfolios as stated in formula (2) will be analysed. The
returns of the hedged portfolio are analysed using both the variance measure as well as the
MSE measure for the entire sample of observations.

VI. Empirical Results

By regressing the returns of the futures on the cash market returns for the in-sample
observations, the OLS hedge ratio was determined. From the 4 examined commodities only the
hedge ratios for the milling wheat market were both low and insignificant. The model of both
the Barcelona and the Lleida market had an r-squared value close to zero. In particular the
local Rotterdam market had a considerable lower t-value and r-square value than the other soy
meal markets. In all cases the estimated hedge ratio is significantly lower than one. The results
with the appropriate t-values are depicted in table III.
Table III

In the table the OLS hedge ratio b*, the corresponding t-value, and the adjusted r-squared value for the different
commodity products and their respective cash markets are depicted. The * indicates that the t-value is significant
at a 10% significance level, ** at a 5% significance level and *** at a 1% significance level.

Commodity Cash market B* t-value adj r^2

Soy Meal Bcn 0.23 3.9*** 0.08
Rot 0.09 1.31* 0.01
Ham 0.36 5.27*** 0.28
Uk 0.24 3.97*** 0.09
Soy Oil Rot 0.41 8.71*** 0.24
Corn Bcn 0.31 8.1*** 0.22
Llei 0.18 4.35*** 0.07
Milling wheat Bcn 0.02 1.34* 0.01
Llei -0.01 -0.42 0

To test for cointegration between series we have first checked the unit root of the
natural log prices of each series separately. The obtained ADF and PP results11 show that for
all series the null hypothesis of unit root cannot be rejected. This means that all series are
indeed non-stationary. For each of the cash series the cointegration with its corresponding

1 T
10
I (θ ) = ∑ I t (θ ) Where I (θ ) = 1 / 2 log(2π ) − 1 / 2 log H t − 1 / 2ε t H t−1ε t
T t =1
11
An overview of all results on the unit root tests on the series can be found in the Appendix, Table XI.
futures series in verified next. ADF and PP tests12 now indicate that the null hypothesis of unit
root can be rejected, indicating that the series are integrated. This means that a linear
combination between cash and futures prices does exist. For this reason a modification of the
OLS regression by taking into account an error correction term seems plausible. Table IV
shows the MVHR as computed by the ECM model13. The hedge ratios for the Rotterdam soy
meal market and Lleida corn market are not significant. Most hedge ratios are lower than the
ratios computed from the traditional OLS models. Only the milling wheat markets have now
higher hedge ratios and t-values. As expected, the adjusted r-square values are considerably
higher than in the traditional OLS models.

Table IV

The table shows the ECM hedge ratio b*, the corresponding t-value, and the adjusted r-squared value for the
different commodity products and their respective cash markets. The * indicates that the t-value is significant at a
10% significance level, ** at a 5% significance level and *** at a 1% significance level.

Commodity Cash market b* t-value adj r^2

Soy Meal Bcn 0.19 5.11*** 0.50
Rot 0.018 0.48 0.47
Ham 0.35 9.31*** 0.34
Uk 0.18 4.92*** 0.51
Soyoil Rot 0.39 8.65*** 0.32
Corn Bcn 0.024 1.99** 0.23
Llei 0.0005 0.05 0.22
Milling wheat Bcn 0.31 9.22*** 0.44
Llei 0.15 4.59*** 0.44

Before the GARCH models were estimated, several preliminary diagnostic tests on the
logarithmic return series14 were performed. The found negative skewness of the series implies
that the distribution has a longer left tail. The high values of kurtosis indicate that the
distribution is peaked (leptokurtic), implying that more of the variance is due to infrequent
extreme deviations. The results from the Jarque Bera test once more confirm that the series are
not normally distributed. To check for autocorrelation and serial correlation, the Ljung-Box Q
statistic is applied.
The results of the Q-statistic, as examined in the fifth lag, indicate that the null hypothesis of
no correlation up to order 5 is rejected in all series. The second tests for autocorrelation (AC)
do confirm that autocorrelation is present in the series. Since the returns appear to exhibit time-

12
All the ADF and PP results on the unit root test on the residuals can be found in the Appendix, Table XII.
13
An overview of all coefficients of the computed error correction model can be found in the Appendix, Table
XIII.
14
An overview of all results of diagnostic tests on the logarithmic return series can be found in the Appendix,
Table XIV.
varying conditional heteroscedasticity, it makes sense to compute a time-varying hedge ratio
using GARCH models. This study examined three different GARCH models: the CC-GARCH,
the Diagonal VECH and the BEKK model. All the coefficients of the models have been
estimated based on in-sample observations using the Eviews 6 statistical program. The log
likelihood function evaluates the value of the coefficients. From all tested GARCH models the
CC-GARCH model has the highest log likelihood, indicating that the coefficients of this model
are the most significant. The BEKK model is the worst estimated model according to the value
of the log likelihood15. With the computed models the time varying hedge ratios have been
estimated.
The in-sample results16 on the MSE and variance of portfolio returns as computed by
the hedge ratios, are mixed. It cannot be concluded that one model outperforms the others in
computing the MVHR. For all examined markets the hedged portfolio with positions in the
futures market did decrease the risk compared with the unhedged portfolio. In order to
determine the effectiveness of the calculated hedge ratios of the different MVHR models, the
hedge ratios are applied to the post-sample observations17. In table V the result for the Soy
Meal cash markets are depicted. Both the MSE and the variance ratio show that the risk is
decreasing in all 4 markets by creating a hedge on the CBOT futures market. The risk of the
local Hamburg commodity market prices decreases the most and the risk of local prices in the
Rotterdam market the least.

15
An overview of all coefficients and the log likelihood of the different GARCH-based models can be found in
the appendix, Table XIV.
16
An overview the in-sample results of the portfolio return variances based on the hedge ratios of the constructed
models can be found in the appendix, Table XV.
17
The hedge ratios as used for the CBOT and Euronext futures market derived from the different MVHR models
for the post-sample period between August 2007 and December 2008 have been depicted in the Appendix,
Figure I.
 Table V

The table shows the post-sample MSE and the variance results for the Soy Meal commodity for the different
portfolios based on hedge ratios derived from different MVHR models. The percentage of change of both MSE
results and variance results compared to the no hedge portfolio have also been depicted.

cc-
Commodity Cash market No hedge Naive hedge OLS ECM Diag VECH GARCH BEKK
Soy Meal Barcelona MSE 44.38 90.63 37.14 37.63 39.05 38.23 40.59
delta % 0.0 104.2 -16.3 -15.2 -12.0 -13.9 -8.5
variance 152.2 310.5 127.3 129.0 133.8 131.1 139.0
delta % 0.0 104.1 -16.3 -15.2 -12.1 -13.9 -8.7
Rotterdam MSE 72.84 103.09 67.35 71.67 65.06 67.50 72.81
delta % 0.0 41.5 -7.5 -1.6 -10.7 -7.3 0.0
variance 249.7 353.3 230.9 245.7 222.7 231.4 249.6
delta % 0.0 41.4 -7.5 -1.6 -10.8 -7.3 0.0
Hamburg MSE 44.59 70.24 30.56 30.59 31.32 30.43 30.40
delta % 0.0 57.5 -31.5 -31.4 -29.8 -31.8 -31.8
variance 152.9 240.7 104.8 104.9 107.1 104.2 104.1
delta % 0.0 57.4 -31.5 -31.4 -29.9 -31.8 -31.9
UK MSE 44.38 90.63 37.09 37.84 38.09 38.13 40.99
delta % 0.0 104.2 -16.4 -14.7 -14.2 -14.1 -7.6
variance 152.16 310.51 127.16 129.73 130.44 130.73 140.34
delta % 0.0 104.1 -16.4 -14.7 -14.3 -14.1 -7.8

Soy oil in the local Rotterdam commodity market can also be hedged on the CBOT futures
market. The change in variance, by using the hedge ratios computed by the different models, is
approximately between 34% to 37%.

Table VI

The table shows the post-sample MSE and the variance results for the Soy Oil commodity for the different
portfolios based on hedge ratios derived from different MVHR models. The percentage of change of both MSE
results and variance results compared to the no hedge portfolio have also been depicted.

Commodity cash market no hedge naive hedge OLS ECM Diag VECH cc-GARCH BEKK
Soy oil Barcelona MSE 273.15 240.13 172.17 174.50 177.53 172.19 179.22
delta % 0.0 -12.1 -37.0 -36.1 -35.0 -37.0 -34.4
variance 931.23 822.52 587.34 595.23 603.43 587.29 609.51
delta % 0.0 -11.7 -36.9 -36.1 -35.2 -36.9 -34.5

Both the variance and the MSE measures indicate that hedging on the Euronext corn futures
can decrease the local corn commodity price risk. The OLS hedge ratios perform best in this
market. The ECM hedge ratios seem to reduce the variance of the hedged portfolio
significantly less than other hedge ratios.
 Table VII
The table shows the post-sample MSE and the variance results for the Corn commodity for the different portfolios
based on hedge ratios derived from different MVHR models. The percentage of change of both MSE results and
variance results compared to the no hedge portfolio have also been depicted.

Commodity cash market no hedge naive hedge OLS ECM Diag VECH cc-GARCH BEKK
Corn Barcelona MSE 9.30 12.60 6.08 8.93 6.39 6.57 6.50
delta % 0.0 35.5 -34.6 -4.0 -31.3 -29.3 -30.0
variance 30.38 43.79 20.29 29.19 25.90 25.46 26.02
delta % 0.0 44.1 -33.2 -3.9 -14.8 -16.2 -14.4
Lleida MSE 8.70 12.45 6.54 8.70 6.89 6.38 6.54
delta % 0.0 43.1 -24.8 0.0 -20.9 -26.7 -24.9
variance 28.33 43.29 21.47 28.33 23.50 21.63 22.45
delta % 0.0 52.8 -24.2 0.0 -17.0 -23.6 -20.7

Finally the Milling wheat market was examined. For the Barcelona cash market the basis risk
seems actually bigger than the risk of the cash prices, implying that hedging on the Euronext
futures market does not decrease but actually increase risk. The Lleida market does seem to be
more related to the Euronext Milling wheat futures. Surprising however is that the by the OLS
computed hedge ratio is not decreasing risk. However, it is surprising that the hedge ratio
computed by the OLS is not reducing risk and that the hedge ratio found with OLS was not
significant.

Table VIII
The table shows the post-sample MSE and the variance results for the Soy Meal commodity for the different
portfolios based on hedge ratios derived from different MVHR models. The percentage of change of both MSE
results and variance results compared to the no hedge portfolio have also been depicted.

Commodity cash market No hedge naive hedge OLS ECM diag VECH cc-GARCH BEKK
Milling wheat Barcelona MSE 13.28 43.13 13.57 15.29 13.61 14.65 16.75
delta % 0.0 224.9 2.3 15.2 2.6 10.3 26.2
variance 45.13 152.21 46.78 53.23 46.18 51.07 57.37
delta % 0.0 237.3 3.7 17.9 2.3 13.2 27.1
Lleida MSE 11.73 30.39 11.73 10.19 10.28 10.33 10.06
delta % 0.0 159.1 0.0 -13.1 -12.4 -11.9 -14.2
variance 39.98 105.50 39.98 34.95 34.95 35.27 33.99
delta % 0.0 163.9 0.0 -12.6 -12.6 -11.8 -15.0

The construction of a hedge in a highly correlated futures market reduces the variance of
returns significantly in 8 out of the 9 markets. When comparing the effectiveness of the
different models to minimize the variance of the hedged portfolio for the in-sample
observations, it is difficult to determine which model performs best. The overall results show
that the OLS hedge ratio performs best in 5 out of the 9 examined markets. Only the ECM
ratio is slightly better than the OLS ratio in the Soy Meal Hamburg market. The GARCH
models perform in 2 markets better than both the OLS and the ECM ratio. It is difficult to
determine which GARCH model performs best in the studied markets. Nonetheless, the
performance of the CC-GARCH hedge ratio is the most constant in decreasing the variance of
portfolio returns for the 9 examined markets.

VII. Implications and recommendations for further research

The MVHR, as determined by the studied models and tested on post-sample observations,
have different outcomes on the variance of the portfolio in the examined markets. From the
results of the empirical investigation on 9 different commodity cash markets and the
corresponding highly correlated futures markets, it is therefore difficult to determine which
method for computing the MVHR is preferred. The OLS does not take into account time
varying variances, serial correlation or cointegration. However the results do indicate that in 5
out of the 9 investigated markets the OLS based method does give the best results and in 2
markets the variance is only slightly worse than other methods. In addition, the OLS based
method does not require weekly adjustments on the portfolio since the hedge ratio is not
varying over time. Weekly adjustment of the hedge ratio might be fairly costly because of the
incurred transaction costs. For this reason, this study does indicate that the OLS method
present the best MVHR.
The obtained results show that the GARCH ratios are not persistently outperforming
the OLS ratio. These findings are in line with studies from Lien (2002), Bystrom (2003) and
Harris (2007). In theory GARCH based conditional models can exploit the predictability in the
conditional variance-covariance matrix of spot and futures returns. The computed hedge ratios
should therefore lead to improvements in hedging performance. However, Harris (2007) gives
several reasons why the conditional hedging model may fail to improve the hedging
performance compared to other non time-varying MVHR. First, it might be that the
unobserved “integrated” MVHR is not time varying to the extent that it is economically useful.
Second, it is possible that that even though the MVHR it time-varying, it is not predictable.
Third, it may be that while the MVHR may be time-varying and predictable, the GARCH
models on the contrary are ineffective as a forecasting model. To be effective in terms of
hedged portfolio reduction, a conditional hedging model must be both informative and
efficient.
 Although the cash and futures prices seem to be cointegrated in this study, the ECM
model does not provide superior hedge ratios. Other studies from Kroner and Sultan (1993),
Gosh and Clayton (1996) and Floras and Vougas (2004) contradict our findings. According to
their studies, the MVHR is underestimated by not taking into account an error correction term.
Remarkably however, in this study it is found that the ECM ratios are on average lower than
the OLS ratios. In addition, the naïve hedge performs worst of all hedge ratios. The results
support the general criticisms in the literature on the naïve hedge for assuming that the
correlation between the futures and the cash market is at all times perfect. It must be noted that
the setting of the present study differs from the other scholars since in this study we are testing
the hedge ratio by cross-hedging the commodity instead of hedging the underlying against its
nearest futures. As expected, it is found that the relatedness of the futures market to the cash
market is really important. The local cash commodity markets with the lowest correlation to
their corresponding futures exhibit a really low decrease or even an increase in risk by
hedging18.
The empirical study performed in this paper has its limitations. In might be argued that
the number of observations is too limited to draw conclusions. However, it is believed that the
time span of the total sample of almost 6 years provides us with enough data to answer the
proposed research questions of this paper. Furthermore one could criticize the fact that the
examination of 9 local commodity markets is not sufficient to draw general conclusions about
risk reduction of the appropriate model to determine the MVHR in cross hedging. The
reduction in risk will be different for every local market. To determine which model to use for
the estimation of the MVHR, additional research on a larger sample is needed. The year 2008
have been used for the post-sample forecasts in this study. However, that year has been the
year with the highest all time yearly volatility in commodity prices. It is therefore possible that
the found results overstate the possibility of variance reduction in the portfolio by hedging.
Nevertheless, we do not know how the volatility of commodity prices will develop in the
future. It is definitely possible that the volatility of commodity prices will remain at this level
in the coming years.

There are a number of issues, which require further attention. In this study only weekly prices
and their returns are examined. It is expected that the longer the trader is exposed to a certain
risk, the better he will be able to decrease risk using a hedge on the related futures market. In

18
An overview of the correlation between returns and the corresponding change in variance by hedging the
portfolio can be found in figure II in the appendix
the long run the basis risk will be relative smaller compared to the volatility in cash prices.
This means that traders who are exposed for a longer period of time, can even decrease their
exposure to risk to a larger extent than the results in this study show. On the other hand, when
examining daily prices, the basis risks will most likely increase compared with the local
commodity cash price risk. Further research should provide more insight in the exposure of
traders who are holding positions for longer or shorter periods of time.
The use of futures does also introduce a trading risk caused by a possible lack of
liquidity in the future market. A future market is considered liquid if traders can buy or sell
futures contracts quickly without affecting the prices significantly as a consequence of their
transactions. In case de market depth is really thin, the dealings of a trader that wants to close-
out its future position do affect the future prices considerably. As a result the trader’s
transaction costs increase and the hedging effectiveness is affected. Pennings and Meulenberg
(1997), who examined liquidity risk at the Potato futures at the Amsterdam Agricultural Future
market, even propose using an alternative hedging strategy in case the volume trades at a
future market is small or if there are no scalpers on the floor to absorb temporarily order
imbalances. According to the Newedge19 commodity trading desk the lack of liquidity at the
European future markets is, although the liquidity has grown considerably in recent years, still
imposes a risk. In contrary, the CBOT futures markets are considered very liquid.
In order to protect market participants and the integrity of the market, the commodity
market exchanges require deposits from all the market participants. These deposits are called
margin accounts and are set up to cover adverse movements in futures prices and ensure that
participants have sufficient funds to handle losses. At sufficiently high levels to adequately
guard against the risk associated with changing market conditions. A trader has to deposit an
amount of money when taking a position, the so called initial margin. In addition, the trader
has to maintain a sum on its deposit at all times that is at a sufficiently high level to
adequately guard against the risk associated with changing market conditions. Margins are set
by the Exchange based on its analysis of price risk volatility at that time. In times of high
volatility margin requirements become really high. When the margin posted in the margin
account is below the minimum margin requirement, the exchange issues a margin call. The
investor now either has to increase the margin that they have deposited, or they can close out
their position. In case the trader can no longer comply with the margin requirements due to
financial constraints, he is forced to sell of the position. This forced sell-off might destroy a

19
Newedge, as part of the Newedge group, is a Paris based company that offers a global, multi-asset brokerage
services on a range of listed and OTC derivatives and securities.
perfect constructed hedging strategy. The last year the volatility in most commodity markets
has increased extremely and for traders these high margin calls are not only costly but may
also impose a risk that the intended hedging strategy may not be fully implemented in case
they are financially constraint.
In this research it is assumed that the optimal hedge ratio is equal to the minimum
variance hedge ratio. The volumes, contracts, entry and exit points are established prior to the
execution of the hedge. Not deviating from this planned hedging strategy is called “blind
hedging” or “full-cover” hedging. However, Stulz (1996) states that in practice, companies
appear to use a selective hedge strategy, where the execution of the overall hedge strategy can
be fine-tuned to better reflect ongoing market conditions. This means that companies allow
their views of commodity futures prices and local cash prices to influence their hedge ratios. In
case of continuously increasing prices it is unlikely to presume that a producer would stick to
his losing short futures hedges rather than liquidate his futures losses. It is likely that traders
acquire specialized information about the commodity market in the course of their normal
operating activities. In addition, Stulz (1996) believes that for many corporations the goal of
risk management is not variance reduction, but the elimination of lower-tail outcomes. It is
possible to hedge with options on futures instead of futures. Since options have got a different
pay-off structure than futures, one could possibly decrease the possible losses of holding
futures, while still taking advantage of favorable price movements of the hedged position.
However, it should not be forgotten that for buying futures a premium has to be paid and that
rebalancing the portfolio to maintain a full-cover hedge is costly. Further research on risk
reduction using futures options would be very interesting.
The comparisons between the different GARCH-based models also require further
attention. In this study it was found that the hedge ratios derived from CC-GARCH model
performed more constant variance reductions than hedge ratios derived from the Diagonal
VECH or the BEKK model. It would be interesting to test these different models and their
corresponding hedge ratios more extensively against each other.
VIII. Conclusions

In this study I have investigated if the producers (agriculturists), users (industrials) and traders
of commodities who are holding positions in local commodity cash markets can decrease risk
by creating a cross-hedge in a related futures market. With the hedged portfolio the changes in
the value of a position in local commodities are offset by changes in the value of an opposite
futures position. Examined in this study is the optimal combination of a cash and futures
position, which minimizes the variance of the weekly portfolio return and therefore maximizes
the utility of the trader. This minimum variance hedge ratio (MVHR) as derived from different
models based on in-sample observations has been tested for post-sample forecasts to determine
its effectiveness. The mean squared error and the variance of returns are used to measure the
risk of the constructed portfolios. The results indicate that in 5 out of the 9 investigated
markets the hedge ratio as derived from the OLS model performs best. In 2 other markets the
variance is only slightly worse than that of the portfolios that are constructed with other hedge
ratios. It is found that the examined weekly return series are cointegrated and appear to exhibit
time-varying conditional heteroscedasticity. However, no evidence is found that the ECM
model or the conditional GARCH-based model compute consistently better performing MVHR
in the tested markets than the traditional OLS model. Although the found results in this study
are in line with research of Lien (2002), Bystrom (2003) and Harris (2007), they contradict
with many other scholars. It should be noted that the setting of this study differs from other
investigations, since in this study the hedge ratios are tested by cross-hedging the commodity
instead of hedging the underlying of the futures market against its nearest futures contract.
Based on the outcomes, it is difficult to say which conditional GARCH-based model performs
best in determining the MVHR. From the obtained results it seems that the hedge ratios as
derived from the CC-GARCH model shows more constant reductions in variance over the 9
examined markets than the hedge ratios as derived from both the Diagonal VECH and the
BEKK model. The construction of a hedge in a highly correlated futures market reduces the
variance of returns significantly in 8 out of the 9 markets. For 6 out of the 9 different tested
local commodity markets, the variance of the returns are reduced between 37% and 16%. The
results indicate that companies with positions in local commodity cash markets can decrease
risk by the creation of a hedge in a related (foreign) futures market. It was found that the extent
to which the local commodity market returns and the futures returns are related, does affect the
degree of risk reduction from the cross-hedged portfolio.
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Lien, D., Tse, T. K. and Tsui, A. K. C. (2002) Evaluating the hedging performance of the
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Appendix

Table IX

This table provides additional information about the examined commodity cash markets in this study. The cash
market, the name of the product, the corresponding unit of trade and source are shown in this oversight.

Local cash commodity markets

Cash
Commodity market Name product Code Unit Source

EUR/Metric
Soy Oil Rotterdam Soyabean Oil-Crude Dutch Ex-Mil FOB SYOCRDT(P) ton DataStream

Soyameal (Farina de soja)-Barcelona EUR/Metric Departamend d'agricultura

Soy Meal Barcelona FOB ton Catalunya

GDP/Metric
UK Soya meal-UK Produce 49% Oil/Protein SYMPOPR(P) ton DataStream

EUR/Metric
Hamburg Soyameal-Hamburg FOB E/MT SYMHGXM(P) ton DataStream

EUR/Metric
Rotterdam Soya meal-Argentina 45% CIF Rdam SYMAGPL(P) ton DataStream

EUR/Metric Departamend d'agricultura

Corn Barcelona Corn (Moro)-Barcelona FOB ton Catalunya

EUR/Metric Departamend d'agricultura

Lleida Corn-Mercado de Lleida FOB ton Catalunya

Milling Milling Wheat (blat panificable)- EUR/Metric Departamend d'agricultura

Wheat Barcelona Barcelona FOB ton Catalunya

Milling wheat (blat panificable) - EUR/Metric Departamend d'agricultura

Lleida Mercado de Lleida FOB ton Catalunya

Table X

This table provides additional information about the examined commodity futures in this study. The contract
specifications are given for every futures contract.

CBOT Soybean Oil Futures

Contract Size 60,000 pounds (lbs) (~ 27 metric tons)
Deliverable Crude soybean oil meeting exchange-approved grades and standards-see exchange Rules and
Grade Regulations for exact specifications.
Pricing Unit Cents per pound
Tick Size
(minimum 1/100 of a cent ($0.0001) per pound ($6.00 per contract)
fluctuation)
Contract January (F), March (H), May (K), July (N), August (Q), September (U), October (V) &
Months/Symbols December (Z)
Trading Hours GLOBEX (Electronic Platform)
6:00 p.m. - 6:00 a.m. and 9:30 a.m. - 1:15 p.m. central time, Sunday - Friday
OPEN OUTCRY (Trading Floor)
9:30 a.m. - 1:15 p.m. Monday – Friday
2.5 cents per pound expandable to 3.5 cents per pound and then to 5.5 cents per pound when
Daily Price Limit the market closes at limit bid or limit offer. There shall be no price limits on the current month
contract on or after the second business day preceding the first day of the delivery month.
settlement
Physical Delivery
Procedure
Last Trade Date The business day prior to the 15th calendar day of the contract month.
Last Delivery
Second business day following the last trading day of the delivery month.
Date
Product Ticker GLOBEX
Symbols ZL
07=Clearing
OPEN OUTCRY
BO

CBOT Soybean Meal Futures

Contract Size 100 Short Tons (~ 91 metric tons)
Deliverable 48% Protein Soybean Meal, meeting the requirements listed in the CBOT Rules and
Grade Regulations
Pricing Unit Dollars and Cents per short ton
Tick Size
(minimum 10 cents per short ton ($10.00 per contract)
fluctuation)
Contract January (F), March (H), May (K), July (N), August (Q), September (U), October (V) &
Months/Symbols December (Z)
Trading Hours GLOBEX (Electronic Platform)
6:00 p.m. - 6:00 a.m. and 9:30 a.m. - 1:15 p.m. central time, Sunday - Friday
OPEN OUTCRY (Trading Floor)
9:30 a.m. - 1:15 p.m. Monday – Friday
$20 per short ton expandable to $30 and then to $45 when the market closes at limit bid or limit
Daily Price
offer. There shall be no price limits on the current month contract on or after the second business
Limit
day preceding the first day of the delivery month.
Settlement
Physical Delivery
Procedure
Last Trade
The business day prior to the 15th calendar day of the contract month.
Date
Last Delivery
Second business day following the last trading day of the delivery month.
Date
Product Ticker GLOBEX
Symbols ZM
06=Clearing
OPEN OUTCRY
SM

Euronext Corn Futures

Unit of Fifty tons
trading
Origins European Union
tenderable
Quality Yellow and/or red corn, of sound, fair and merchantable quality of the following standard:
Moisture basis 15%, maximum 15.5% Broken grain basis 4%, maximum 10% Sprouted grain
basis 2.5%, maximum 6% Grain admixture basis 4%, maximum 5% Other impurities basis 1%,
maximum 3% The combined element of broken grain, sprouted grain, admixture grain and other
impurities must not exceed 12% Discounts and additional requirements apply in conformity with
Incograin contract n° 23 and Technical Addendum n°5 “Mycotoxins not to exceed, at the time of
delivery, the maximum levels specified under EU legislation in force with respect unprocessed
cereals intended for use in feed products.” The underlying is said to be conventional corn, which
 is defined as a product containing no genetically modified organisms, or containing genetically
modified organisms whose presence is adventitious or technically unavoidable, in accordance
with requirements in force under EU Regulations (1) (1)EC regulation n° 1829/2003 of the
European Parliament and the Council of the 22 September 2003 on genetically modified food
and feed (OJEU 18-10-2003).
Delivery November, January, March, June and August such that seven delivery months are available for
months trading
Price basis Euros and Euro cents per tonne, in an approved public silo in : Bayonne : silo MAÏSICA - Blaye
: silo SEMABLA - Bordeaux : silos d’AQUITAINE INVIVO, SPLB/SOBtran - La Rochelle
Pallice : silos SICA ATLANTIQUE, SOCOMAC - Nantes : silo SONASTOCK.
Quotation Euros and Euro cents per ton
Minimum 25 Euro cents per metric tonne (12.50€)
price
movement
(tick size and
value)
Last trading 18.30 on the fifth calendar day of the delivery month. If not a business day, then the first
day following business day
Notice The first business day following the last trading day
day/Tender
day
Tender period Any business day from the last trading day to the end of the specified delivery month
Delivery Any business day from the last trading day to the end of the specified delivery month
period
Trading hours 10.45 - 18.30

Euronext Milling Wheat Futures

Unit of trading Fifty tonnes
Origins tenderable EU origin
Quality Sound, fair and merchantable quality of the following standard:
Specific weight 76 kg/hl
Moisture 15%
Broken grains 4%
Sprouted grains 2%
Impurities 2%

Premiums and discounts to reflect the difference between the delivered and the standard
quality apply in accordance with Incograin Contract No.23 and the Technical Addendum
No.2
Delivery months January, March, May, August, November such that eight delivery months are available for
trading
Price basis Euros and Euro cents per tonne, in an approved public silo in Rouen, France
Minimum price 25 Euro cents per tonne
movement (€12.50)

Last trading day 18.30 on the tenth calendar day of the delivery month (if not a business day, then the
following business day)
Notice The first business day following the last trading day
day/Tender day
Tender period Any business day from the last trading day to the end of the specified delivery month
Trading hours 10.45 - 18.30

Table XI

This table shows the Unit root test for the both the local cash commodity markets and their corresponding futures
market. The augmented Dickey-Fuller test and the Phillips-Perron test have been performed to check for unit root.
The null hypothesis that the series do contain a unit root is tested. The * indicates that the t-value is significant at
a 10% significance level, ** at a 5% significance level and *** at a 1% significance level.

Commodity cash market ADF PP

Soy Meal Bcn -1.801 -1.872
Rot -1.601 -1.630
Ham -2.528 -2.342
uk -1.871 -1.974
Fut -2.378 -2.228
Soy Oil Rot -0.805 -0.698
Fut -1.313 -1.445
Corn Bcn -0.121 -0.187
Llei -0.511 -0.215
Fut -0.073 -0.254
Milling Wheat Bcn -0.996 -1.313
Llei -1.341 -1.437
Fut -1.112 -1.354

Table XII

This table shows the Unit root test performed on the residuals on the regression log Ct = a + b log Ft + ε t The
augmented Dickey-Fuller test and the Phillips-Perron test have been performed to check for unit root. The null
hypothesis that the series do contain a unit root is tested. The * indicates that the t-value is significant at a 10%
significance level, ** at a 5% significance level and *** at a 1% significance level.

Commodity cash market ADF PP

Soy Meal Bcn-fut -4.95*** -7.30***
rot-fut -2.08 -3.66***
Ham-fut -4.25*** -4.22***
uk-fut -5.16*** -7.46***
Soy Oil rot-fut -2.38 -3.59***
Corn Bcn-fut -3.57*** -3.47***
Llei-fut -3.99*** -3.80***
Milling Wheat Bcn-fut -3.98*** -4.16***
Llei-fut -4.13*** -4.13***
 Table XIII
This table shows the entire results from the ECM regression of the different local cash commodity and their
corresponding futures markets. The series are tested for unit root. The appropriate values for the number of F lags
and C lags are determined based on the Akaike (1974) information criterion. The corresponding t-value of each
coefficient has depicted noted between brackets. The corresponding R-square value and log likelihood is given for
every model.

Product soyoil soymeal corn wheat

Market Rot rot Ham Uk Bcn bcn llei bcn llei

delta_F(-1) 0.246066 0.513377 -0.006851 0.553275 0.546043 -0.046155 0.348279 0.282451 0.14754
[ 4.73450] [ 13.7322] [-0.10220] [ 14.3772] [ 13.8758] [-3.65596] [ 5.06802] [ 4.09562] [ 4.25072]

delta_F(-2) 0.005276 -0.113731 0.028654 0.110824 0.108288 0.13144 -0.01663 0.049646 0.069491
[ 0.09666] [-2.25679] [ 0.42860] [ 2.09734] [ 2.02981] [ 2.61817] [-0.22697] [ 0.59257] [ 1.89363]

delta_F(-3) 0.02213 -0.10239 -0.080513 0.047891 0.061 0.118674 -0.017628 -0.007534 0.04173
[ 0.40442] [-2.00032] [-1.21705] [ 0.89936] [ 1.11834] [ 2.32358] [-0.24362] [-0.09033] [ 1.13545]

delta_F(-4) -0.018713 -0.024374 -0.027387 0.006888 0.012785 0.112742 0.053138 -0.035698 0.108126
[-0.34328] [-0.47928] [-0.43067] [ 0.13337] [ 0.23779] [ 2.17213] [ 0.79466] [-0.47006] [ 2.96803]

delta_C(-1) -0.279084 0.070879 0.175526 -0.218701 -0.229587 0.174638 -0.017078 0.126503 0.160173
[-4.19399] [ 1.06402] [ 3.96979] [-3.29612] [-3.41835] [ 2.45561] [-1.53796] [ 3.21329] [ 2.33817]

delta_C(-2) 0.073258 0.097895 -0.120087 -0.100479 -0.115152 0.11565 0.113669 0.096843 0.441239
[ 1.05004] [ 1.46724] [-2.64801] [-1.47896] [-1.66007] [ 1.60945] [ 2.47175] [ 2.43151] [ 6.31911]

delta_C(-3) 0.005924 0.002968 -0.005347 -0.052093 -0.06075 -0.020136 0.125969 0.057305 -0.078276
[ 0.08478] [ 0.04449] [-0.11553] [-0.77991] [-0.88694] [-0.28122] [ 2.71274] [ 1.42924] [-1.03726]

delta_C(-4) 0.031591 0.052349 0.033694 -0.054783 -0.065091 0.003227 0.010469 -0.00995 -0.18107
[ 0.48593] [ 1.06864] [ 0.72475] [-1.13680] [-1.31612] [ 0.04768] [ 0.22123] [-0.25305] [-2.55291]

Alpha 0.519449 0.45639 0.084012 0.109017 0.007903 0.163169 0.119157 0.072528 0.097732
[ 0.77420] [ 1.17400] [ 0.21301] [ 0.28618] [ 0.02037] [ 0.98245] [ 0.79761] [ 0.53617] [ 0.75650]

delta_F 0.388363 0.017953 0.351842 0.178522 0.190636 0.023829 0.000548 0.310103 0.152455
[ 8.64933] [ 0.48619] [ 9.31327] [ 4.92149] [ 5.11497] [ 1.99042] [ 0.05102] [ 9.21691] [ 4.59786]

Adj. R-squared 0.31541 0.470463 0.342838 0.50774 0.504011 0.234425 0.222602 0.435824 0.44173
Log likelihood 6477.078 7063.485 6824.921 7090.094 6871.589 7102.797 7466.019 7426.193 7352.556
 Table XIV

The table provides an overview of the most important diagnostic tests on the return series of the log normal prices
models and their corresponding findings. The standard deviation, the skewness, and the kurtosis are checked for
all local commodity markets. Next, the Jarque-Bera test is performed to test for normality. The Ljung-Box Q
statistic is used for lag 5 to determine the existence of autocorrelation in the series.

Commodity Soy Oil Soy Meal Corn Wheat

Market Rot Rot Ham Uk Bcn bcn llei Bcn llei
Mean 0.000967 0.001879 0.00089 0.000285 0.000642 0.002303 0.002403 0.001856 0.001883
Median 0 0 0 0 0 0 0 0 0
Maximum 0.097 0.116 0.100 0.121 0.121 0.109 0.077 0.073 0.093
Minimum -0.086 -0.138 -0.150 -0.138 -0.138 -0.078 -0.115 -0.079 -0.067
Std. Dev. 0.025 0.033 0.036 0.037 0.037 0.015 0.015 0.017 0.015
Skewness -0.024 -0.345 -0.337 -0.123 -0.135 0.776 -1.336 -0.105 0.813
Kurtosis 4.590 6.008 4.638 4.322 4.374 15.167 19.589 8.276 12.854

Jarque-Bera 25.31047 95.24118 31.37074 18.0769 19.60353 1504.376 2823.235 276.4358 997.39
Probability 0.000003 0 0 0.000119 0.000055 0 0 0 0

AC (5) 0.788 0.803 0.769 0.84 0.842 0.89 0.889 0.929 0.953
Q-Stat (5) 936.31 947.76 902.68 996.07 1006.4 1162 1162.2 1360.9 1503.4
Probability Q (5) 0 0 0 0 0 0 0 0 0

Table XV

This table shows the all the estimated coefficients from the three GARCH-based tested models; the constant
correlation GARCH model (CC-GARCH), the Diagonal VECH model and the BEKK model. For every model the
log likelihood value is depicted. In this table the results for the Soy Meal cash markets and the CBOT Soy Meal
futures can be found.

Market Rot market ham

CC-GARCH Diagonal Vech BEKK CC-GARCH Diagonal Vech BEKK
c01 0.000106 0.000115 7.2E-07 0.000131 0.000169 0.0000385
c02 0.000000688 0.000000711 0.000101 0.000253
c03 0.00000101 0.000375
a11 0.161899 0.17134 0.29938 0.05172 0.068367 0.196761
a22 0.639801 0.607567 0.82527 0.132438 0.131925 0.368729
a33 -0.03351 0.111324
g11 0.808666 0.796839 0.96398 0.84531 0.808998 0.966891
g22 0.642249 0.651684 0.80113 0.833402 0.755361 0.935868
g33 0.925086 0.504356
Correlation 0.067052 0.551845
Log likelihood 939.6302 940.7017 929.064 920.0241 924.6388 919.3977
Akaike info criterion -7.755252 -7.747514 -7.6839 -7.591868 -7.613657 -7.603314
 Market Uk market bcn
CC-GARCH Diagonal Vech BEKK CC-GARCH Diagonal Vech BEKK
C01 0.000103 0.0000918 0.0000227 0.000101 0.000135 0.0000241
C02 0.0001 0.000116 0.0000776 0.000085
C03 0.000767 0.0000303
A11 0.083612 0.068774 0.012743 0.141834 0.12572 0.329969
A22 0.140349 0.131322 0.323214 0.072639 0.069542 0.032826
A33 0.0735 -0.017907
G11 0.840348 0.863836 0.989502 0.826563 0.823151 0.946592
G22 0.828279 0.82818 0.948695 0.870523 0.869096 0.989417
G33 -0.816955 0.952207
Correlation 0.269167 0.254716
Log likelihood 877.6685 878.8782 871.811 877.6238 880.7598 873.4919
Akaike info criterion -7.238904 -7.232318 -7.206758 -7.238532 -7.247999 -7.220766

Table XVb

This table shows the all the estimated coefficients from the three GARCH-based tested models; the constant
correlation GARCH model (CC-GARCH), the Diagonal VECH model and the BEKK model. For every model the
log likelihood value is depicted. In this table the results for the Rotterdam soy oil cash markets and the CBOT Soy
oil futures can be found.

Market rot
CC-GARCH Diagonal Vech BEKK
C01 0.00000747 0.00000737 4.7E-06
C02 0.000735 0.0000505
C03 0.00028
A11 -0.050005 -0.049289 0.08699
A22 0.109333 0.028131 0.25619
A33 0.064233
G11 1.029787 1.029941 0.98841
G22 0.213709 0.925807 0.96642
G33 0.211584
R 0.501004
Log likelihood 1077.678 1082.673 1068.42
Akaike info criterion -8.90565 -8.930608 -8.8451

Table XVc

This table shows the all the estimated coefficients from the three GARCH-based tested models; the constant
correlation GARCH model (CC-GARCH), the Diagonal VECH model and the BEKK model. For every model the
log likelihood value is depicted. In this table the results for the tested corn cash markets and the Euronext corn
futures can be found.

market Bcn market Lleida

CC-GARCH Diagonal Vech BEKK CC-GARCH Diagonal Vech BEKK
c01 0.000054 0.0000693 9.6E-05 0.0000245 0.0000274 0.0000272
c02 0.000113 0.000112 0.0000485 0.0000549
c03 0.0000584 0.00000741
 a11 0.273731 0.312708 0.49139 0.519417 0.454893 0.713225
a22 0.619779 0.599984 0.64484 0.276856 0.255011 0.135735
a33 0.200198 0.085775
g11 0.697144 0.650676 0.81811 0.528447 0.543906 0.735445
g22 -0.081209 -0.082474 -0.3231 0.705924 0.711978 0.973194
g33 0.132161 0.839607
correlation 0.341049 0.294712
Log likelihood 1281.402 1280.631 1270.72 1276.49 1276.209 1258.316
Akaike info criterion -10.60335 -10.58026 -10.531 -10.56241 -10.54341 -10.42764

Table XVd

This table shows all the estimated coefficients from the three tested GARCH-based models; the constant
correlation GARCH model (CC-GARCH), the Diagonal VECH model and the BEKK model. For every model the
log likelihood value is depicted. In this table the results for the milling wheat cash markets and the milling wheat
futures can be found.

Market Bcn market Lleida

CC-GARCH Diagonal Vech BEKK CC-GARCH Diagonal Vech BEKK
c01 0.0000303 0.000029 1.9E-05 0.000171 0.000171 0.0000523
c02 0.0000253 0.0000264 0.0000312 0.0000305
c03 0.00000501 0.00000781
a11 0.274371 0.260859 0.23174 0.50612 0.512723 0.463354
a22 0.285329 0.286487 0.65803 0.248523 0.239097 0.532393
a33 -0.074057 0.251485
g11 0.723952 0.738215 0.96638 -0.038787 -0.034528 -0.757143
g22 0.679403 0.674327 0.81649 0.736189 0.747128 0.826602
g33 0.892821 0.139384
correlation 0.124171 0.141814
Log likelihood 1243.863 1247.246 1213.69 1276.368 1275.925 1267.818
Akaike info criterion -10.377 -10.38863 -10.14 -10.5614 -10.54104 -10.50681

Table XVI

The following tables show the in-sample MSE and the variance results for the soy meal, the soy oil, the corn and
the milling wheat commodity for the different portfolios based on hedge ratios derived from different MVHR
models. The percent of change of both MSE results and variance results compared to the no hedge portfolio have
also been depicted.

cash naive
Commodity market no hedge hedge OLS ECM diag vech cc-garch BEKK

Soy Meal bcn MSE 71.13 132.84 65.04 65.23 66.41 66.99 66.44

delta % 0.0 86.8 -8.6 -8.3 -6.6 -5.8 -6.6

variance 71.4 133.9 65.4 33.0 33.9 34.0 33.6

delta % 0.0 87.6 -8.4 -53.7 -52.5 -52.4 -52.9

rot MSE 395.11 172.94 349.41 385.99 109.20 124.39 112.25

delta % 0.00 -56.23 -11.57 -2.31 -72.36 -68.52 -71.59

variance 64.1 159.3 63.3 63.8 90.9 109.1 113.0

delta % 0.0 148.4 -1.3 -0.5 41.7 70.2 76.3

ham MSE 54.77 85.87 39.58 39.60 46.85 60.36 60.90

 delta % 0.0 56.8 -27.7 -27.7 -14.5 10.2 11.2

variance 54.4 86.5 39.5 39.5 47.2 60.7 61.4

delta % 0.0 59.1 -27.4 -27.4 -13.3 11.6 12.9

uk MSE 71.63 131.97 65.22 65.62 62.05 63.29 65.58

delta % 0.0 84.3 -8.9 -8.4 -13.4 -11.6 -8.4

variance 71.89 133.04 65.59 65.95 62.45 63.72 66.01

delta % 0.0 85.1 -8.8 -8.3 -13.1 -11.4 -8.2

cash naive
Commodity market no hedge hedge OLS ECM diag vech cc-garch BEKK

Corn bcn MSE 7.31 13.02 5.68 7.09 5.95 5.77 5.56

delta % 0.0 78.0 -22.3 -3.1 -18.6 -21.1 -24.0

variance 7.17 12.82 5.56 6.95 5.69 5.57 5.21

delta % 0.0 78.8 -22.5 -3.1 -20.7 -22.3 -27.4

Lleida MSE 6.78 12.45 6.54 8.70 6.89 6.38 6.54

delta % 0.0 83.7 -3.5 28.4 1.6 -5.9 -3.6

variance 5.75 15.18 5.14 5.75 7.67 8.43 10.38

delta % 0.0 163.8 -10.7 0.0 33.3 46.5 80.4

cash naive
Commodity market no hedge hedge OLS ECM diag vech cc-garch BEKK
Milling
wheat bcn MSE 8.21 16.76 7.83 8.08 8.05 8.17 8.99

delta % 0.0 104.1 -4.7 -1.7 -2.0 -0.6 9.4

variance 6.97 16.72 6.86 7.32 6.83 6.94 7.80

delta % 0.0 139.8 -1.6 5.0 -2.1 -0.5 11.9

Lleida MSE 6.57 14.08 6.57 6.03 7.53 6.11 9.24

delta % 0.0 114.5 0.0 -8.1 14.7 -7.0 40.7

variance 6.12 14.19 6.12 5.73 7.35 5.96 8.76

delta % 0.0 132.0 0.0 -6.3 20.2 -2.6 43.2

cash naive
Commodity market no hedge hedge OLS ECM diag vech cc-garch BEKK

Soy oil bcn MSE 273.15 240.13 172.17 174.50 177.53 172.19 179.22

delta % 0.0 -12.1 -37.0 -36.1 -35.0 -37.0 -34.4

variance 156.71 197.87 118.70 118.80 117.70 119.56 123.35

delta % 0.0 26.3 -24.3 -24.2 -24.9 -23.7 -21.3

 Figure I

In the figure the hedge ratios as used for the CBOT and Euronext futures market derived from the different
MVHR models for the post-sample period between August 2007 and December 2008 have been depicted. The
figures are named after the commodity cash market and the depicted hedge ratios are to be applied in the
corresponding futures market.
naive
Soy Meal UK
1.2
OLS
1

ECM
0.8

0.6
Diagonal
VECH
0.4

CC-
0.2
GARCH
0
BEKK
17-8-07 17-1-08 17-6-08 17-11-08
- 0.2

naive
Soy Meal Hamburg
1.2
OLS

ECM
0.8

0.6 Diagonal
V ECH
0.4
CC-
0.2 GARCH

0
BEKK
17-8-07 17-1-08 17-6-08 17-11-08

naive
Soy Meal Rotterdam

1.2
OLS
1

0.8 ECM

0.6

Diagonal
0.4
VECH
0.2
CC-
0 GARCH
17-8-07 17-1-08 17-6-08 17-11-08
- 0.2 BEKK
- 0.4
 naive
Soy meal Barcelona

1.2
OLS
1

ECM
0.8

0.6
Diagonal
V ECH
0.4

CC-
0.2
GARCH
0
BEKK
17-8-07 17-1-08 17-6-08 17-11-08
- 0.2

OLS
Soy Oil Rotterdam

1.2
ECM

Diagonal
0.8 VECH

0.6 CC-
GARCH
0.4
BEKK
0.2

0
naive
31-8-07 31-1-08 30-6-08 30-11-08

naive
Corn Barcelona

1.2
OLS
1

0.8 ECM

0.6

Diagonal
0.4
VECH
0.2
CC-
0 GARCH
17-8-07 17-1-08 17-6-08 17-11-08
- 0.2 BEKK
- 0.4

naive
Corn Lleida
1.2
OLS

ECM
0.8

0.6 Diagonal
V ECH
0.4
CC-
0.2 GARCH

0
BEKK
17-8-07 17-1-08 17-6-08 17-11-08
 naive
Milling w heat Barcelona

1.2
OLS
1

0.8
ECM
0.6

0.4
Diagonal
0.2
V ECH
0
17-8-07 17-1-08 17-6-08 17-11-08 CC-
- 0.2
GA RCH
- 0.4

- 0.6 BEKK
- 0.8

naive
Milling w heat Lleida

1.2
OLS
1

0.8
ECM
0.6

0.4 Diagonal
0.2
V ECH

0 CC-
17-8-07
- 0.2
17-1-08 17-6-08 17-11-08 GARCH

- 0.4 BEKK
- 0.6

Figure II

In this figure the post-sample change in variance of the portfolio returns using the OLS hedge ratio have been
depicted with the corresponding correlation between the commodity cash and the related weekly futures returns.

0
0 0,5 1
Change in variance portfolio

-5
from OLS hedge (%)

-10

-15

-20

-25

-30

-35

-40
Correlation returns