Comparing hedging effectiveness: An application of the encompassing principle

Dwight R. Sanders, Mark Manfredo

Research output: Contribution to journalArticle

11 Scopus citations

Abstract

An empirical methodology is developed for statistically testing the hedging effectiveness among competing futures contracts. The presented methodology is based on the encompassing principle, widely used in the forecasting literature, and applied here to minimum variance hedging regressions. Intuitively, the test is based on an alternative futures contract's ability to reduce residual basis risk by offering either diversification or a smaller absolute level of basis risk than a preferred futures contract. The methodology is easily extended to cases involving multiple hedging instruments and general hedge ratio models. Empirical applications suggest that the encompassing methodology can provide information beyond traditional approaches of comparing hedging effectiveness.

Original languageEnglish (US)
Pages (from-to)31-44
Number of pages14
JournalJournal of Agricultural and Resource Economics
Volume29
Issue number1
StatePublished - Apr 1 2004

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Keywords

  • Cross-hedging
  • Encompassing
  • Hedging effectiveness

ASJC Scopus subject areas

  • Animal Science and Zoology
  • Agronomy and Crop Science
  • Economics and Econometrics

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