The (De)Merits of Minimum-Variance Hedging: Application to the Crack Spread

Abstract

We study the empirical performance of the classical minimum-variance hedging strategy, comparing several econometric models for estimating hedge ratios of crude oil, gasoline and heating oil crack spreads. Given the great variability and large jumps in both spot and futures prices, great care is required when processing the relevant data and accounting for the costs of maintaining and re-balancing the hedge position. We find that the variance reduction produced by all models are statistically and economically indistinguishable from the one-for-one naive hedge. However, minimum-variance hedging models, especially those based on GARCH, generate much greater margin and transaction costs than the naive hedge. Therefore we encourage hedgers to use a naive hedging strategy on the crack spread bundles now offered by the exchange as it is the cheapest and easiest to implement. Our conclusion contradicts the majority of the existing literature, which favours the implementation of GARCH-based hedging strategies.