Derivative pricing model and time-series approaches to hedging: A comparison

Authors

  • Henry L. Bryant,

    1. Texas A&M University, College Station, Texas
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  • Michael S. Haigh

    Corresponding author
    1. U.S. Commodity Futures Trading Commission, Washington, DC
    2. University of Maryland, College Park, Maryland
    • Senior Financial Economist, Office of the Chief Economist, U.S. Commodity Futures Trading Commission, 1155 21st Street N.W., Washington, DC 20581
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Abstract

This research compares derivative pricing model and statistical time-series approaches to hedging. The finance literature stresses the former approach, while the applied economics literature has focused on the latter. We compare the out-of-sample hedging effectiveness of the two approaches when hedging commodity price risk using futures contracts. For various methods of parameter estimation and inference, we find that the derivative pricing models cannot out-perform a vector error-correction model with a GARCH error structure. The derivative pricing models' unpalatable assumption of deterministically evolving futures volatility seems to impede their hedging effectiveness, even when potentially foresighted optionimplied volatility term structures are employed. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:613–641, 2005

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