The Effect of the Hedge Horizon on Optimal Hedge Size and Effectiveness When Prices are Cointegrated

Authors


  • We thank Henk Berkman, Audra Boone, Bob DeYoung, Jeff Mercer, Shane Moriarity, Panos Patatoukas, Peter Wells, Jide Wintoki, and seminar participants at the University of Kansas, University of Auckland, Massey University, the American Accounting Association Conference, the Financial Management Association Conference, and the Southern Finance Association Conference.

School of Business, University of Kansas, Lawrence, Kansas 66045

Abstract

This study compares two alternative regression specifications for sizing hedge positions and measuring hedge effectiveness: a simple regression on price changes and an error correction model (ECM). We show that, when the prices of the hedged item and the hedging instrument are cointegrated, both specifications yield similar results which depend on the hedge horizon (i.e., the time frame for measuring price changes). In particular, the estimated hedge ratio and regression R2 will both be small when price changes are measured over short intervals, but as the hedge horizon is lengthened both measures will converge toward one. These results imply that, when prices are cointegrated, a longer hedge horizon will yield an optimal hedge ratio closer to one, while at the same time enhancing the ability to qualify for hedge accounting. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark 32:837–876, 2012

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