Adjusting stacked-hedge ratios for stochastic convenience yield: a minimum variance approach

Abstract

Absent liquidity in long-term futures or forward markets, firms use nearby contracts to hedge long-term commitments. To hedge commodities that exhibit stochastic convenience yield, adjustments to the naive stacked hedge are necessary. Simulated and empirical tests of the hedging model using oil, copper, soybeans, gold and yen show that a stacked hedge reduces the volatility of terminal wealth. For commercial commodities, adjusting the hedge for stochastic convenience yield further reduces volatility. Kalman filter methods are used to estimate the parameters in the underlying.