Hedging Positions Research Articles

Making Mean-Variance Hedging Implementable in a Partially Observable Market

The mean-variance hedging (MVH) problem is studied in a partially observable market where the drift processes can only be inferred through the observation of asset or index processes. Although most of the literatures treat the MVH problem by the duality method, here we study a system consisting of three BSDEs derived by Mania and Tevzadze (2003) and Mania et.al.(2008) and try to provide more explicit expressions directly implementable by practitioners. Under the Bayesian and Kalman-Bucy frameworks, we find that a relevant BSDE yields a semi-closed solution via a simple set of ODEs which allow a quick numerical evaluation. This renders remaining problems equivalent to solving European contingent claims under a new forward measure, and it is straightforward to obtain a forward looking non-sequential Monte Carlo simulation scheme. We also give a special example where the hedging position is available in a semi-closed form. For more generic setups, we provide explicit expressions of approximate hedging portfolio by an asymptotic expansion. These analytic expressions not only allow the hedgers to update the hedging positions in real time but also make a direct analysis of the terminal distribution of the hedged portfolio feasible by standard Monte Carlo simulation.

The Collapse of Metallgesellschaft (MG): Hedging or Speculation

In 1993 Metallgesellschaft nearly collapsed after a series of hedging transaction that lead the company into a severe liquidity crisis. Only a big rescue operation by a banking consortium to provide liquidity allowed Metallgesellschaft to continue operation. This paper is analyzing certain aspects of this near collapse such as the basic principle of the hedge strategy applied, it’s short and long term potential consequences as well as the risks associated with taking on such large positions. The paper tackles the hedge from different perspectives. The quantitative analysis simulates the risks that MGRM has been taken on while the qualitative analysis looks at aspects such as the timing of the hedging, the comparatively large position with regards to the total market in oil futures as well as the basic risks taken by MGRM. The paper also takes a closer look at the different analysis provided by financial experts that is divided into two camps; the one arguing that the hedge would have been ultimately effective while the other camp supporting the opinion that those big hedge positions are ultimately being seen as a speculation. In contrast to the analysis done by Henke, Culp and Miller who neglected the interest rate this paper shows how interest rate plays a major role in the full effect of the hedge strategy being entered. Finally the role of the management is being analyzed as having the most detrimental effect on the final outcome of the situation and the fact that MG nearly collapsed due to the decision the new management took at that time.

Interest Rate Derivatives and Firm Value: Evidence from Mandatory Versus Voluntary Hedging

This paper examines the impact of interest rate derivatives enforced by creditors and interest rate derivatives used voluntarily on firm value, separately in a sample of 3881 firm-years from 1998 to 2005. Voluntary hedging positions include derivatives for corporate risk management practices and those for private benefit of managers. Consequently, these derivatives might not have the positive impact on firm value predicted by risk management theories. However, there is no managerial incentive in the use of derivatives mandated by credit agreements. Therefore, shareholders refer to mandatory term of derivatives obliged by creditors and classify these instruments as real risk management practices and reward such positions by a premium on firm value. This argument is strongly supported by the results of this empirical research in which we find an economically large and statistically significant positive impact from mandatory interest rate derivatives on firm value and no significant impact from voluntary ones.

Returns and option activity over the option-expiration week for S&P 100 stocks

For S&P 100 stocks, we find that the weekly returns over option-expiration (OE) weeks (a month’s third-Friday week) tend to be high, relative to: (1) the third-Friday weekly returns of other stocks with less option activity, (2) the own stock’s other weekly returns, (3) the risk, based on asset-pricing alphas. For these same stocks, a month’s fourth-Friday weekly returns underperform modestly. We suggest the following two avenues are likely partial contributors towards understanding these return patterns: (1) delta-hedge rebalancing by option market makers, with a reduction in short-stock hedge positions over the OE week, and (2) declining risk perceptions over the OE week, as measured by option-derived implied volatilities. Our findings suggest option activity can induce reliable patterns in the weekly returns of option-active large-cap stocks.

The failure of risk management for nonfinancial companies in the context of the financial crisis: lessons from Aracruz Celulose and hedging with derivatives

The main contribution of this article is to present hard evidence on hedging strategies and relate it to behavioural and agency problems resulting from speculation with derivatives. We focus on the case of Aracruz Celulose. We show how the real hedge position of Aracruz – that lost US2.1 billion in currency derivatives – deviated from its optimal hedge as the result of speculation with Over-the-Counter (OTC) derivatives.

Self-Funding Portfolios and Collateralised Derivative Pricing

A general framework is proposed for including the effects of collateral management in derivative pricing. Comprehensive yet simple formulas are obtained allowing the impact of different types of collateral agreements to be incorporated in valuations. The approach centers on analysing the self-financing condition on portfolios which explicitly include the market funding of derivative, collateral and hedging positions. Major simplifications, including a martingale pricing formula, are obtained when funding and collateral are in the form of cash, but the general framework aims at greater generality. The functional dependence of the collateral balance on the value of the derivative also plays a central role in the analysis. The “institutional” implications for liquidity management (pertaining to derivative desk funding, bank treasury “transfer pricing,” and the interplay with the repo market) are briefly considered.

Pricing and Hedging Asian-Style Options in Energy

We solve the problem of pricing and hedging Asian-style options on energy with a quadratic risk criterion when trading in the underlying future is restricted. Liquid trading in the future is only possible up to the start of a so-called delivery period. After the start of the delivery period, the hedge positions can not be adjusted anymore until maturity. This reflects the trading situation at the Nordic energy market Nord Pool for example. We show that there exists a unique solution to this combined continuous-discrete quadratic hedging problem if the future price process is a special semimartingale with bounded mean-variance tradeoff. Additionally, under the assumption that the future price process is a local martingale, the hedge positions before the averaging period are inherited from the market specification without trading restriction. As an application we consider three models and derive their quadratic hedge positions in explicit form, a simple Black Scholes model with time-dependent volatility, the stochastic volatility model of Barndorff-Nielsen and Shephard and an exponential additive model. Based on an exponential spot price model driven by two NIG \levy processes, we determine an exponential additive model for the future price by moment matching techniques. We calculate hedge positions and determine the quadratic hedge error in a simulation study.

The (de)merits of minimum-variance hedging: Application to the crack spread

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, considerable 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 is statistically and economically indistinguishable from the one-for-one “naïve” hedge. However, minimum-variance hedging models, especially those based on GARCH, generate much greater margin and transaction costs than the naïve hedge. Therefore we encourage hedgers to use a naïve hedging strategy on the crack spread bundles now offered by the exchange; this strategy 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.

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

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.

Dynamic Asset Allocation under Regime Switching Predictability and Parameter Uncertainty

This paper solves the dynamic asset allocation problem under stock return predictability based on the dividend price ratio with regime shifts and parameter uncertainty in a fully Bayesian framework. Intertemporal hedging demands are simultaneously induced by predictability, regime shifts, parameter uncertainty, and learning about the regimes. Optimal policies display non-monotonic horizon effects whereby regime shifts tend to induce negative hedge demands in the short-run, while predictability induces positive hedge demands in the long-run. The economic costs of ignoring regime switching and predictability are high even in the light of regime and parameter uncertainty.

Discussion of “Hedge commitments and agency costs of debt: evidence from interest rate protection covenants and accounting conservatism”

Beatty, Petacchi, and Zhang investigate the role of two hedge commitment mechanisms—interest rate protection covenants and accounting conservatism—in reducing agency costs of debt. Using a large sample of syndicated loan agreements, they provide evidence that borrowers required to hedge interest rate risk through interest rate protection covenants receive lower interest rate charges. However, borrowers who voluntarily hedge interest rate risks receive lower rates only if they implement conservative financial reporting. The authors conclude that the benefits of hedging are realized only when borrowers can credibly commit to maintain hedge positions once a syndicated loan is issued. While the evidence provided by the authors is novel and interesting, I argue that the empirical assessment of hedge benefits is more complex. In addition, there are still some important open issues left unanswered that could be tackled by future research.

Hedge commitments and agency costs of debt: evidence from interest rate protection covenants and accounting conservatism

We provide large sample evidence that credible hedge commitments reduce the agency costs of debt and that accounting conservatism enhances hedge commitments. We examine 2,338 bank loans entered into by 263 mandatory derivative users that are contractually obligated by interest rate protection covenants, 709 voluntary derivative users, and 1,366 non-users. We show that loan contracts are more likely to include interest rate protection covenants when borrowers are less likely to maintain the hedge position once the financing is completed. We find that borrowers who credibly commit to hedge using these covenants significantly reduce their interest rates. While we do not find an average interest savings for voluntary derivative users, we do find a reduction in their loan rates when they practice conservative financial reporting. Our results suggest that accounting conservatism helps borrowers resolve shareholder-creditor conflicts by committing to maintain their hedge positions after completing debt financing.

Analytical Approximations for Loan and Credit Derivatives Portfolios

Banks often seek to reduce the default risk exposure associated with their corporate loan portfolios by entering into credit derivative positions. They can, for example, buy default protection on selected borrowers, or diversify the portfolio by selling protection on other names. The design of suitable credit derivative positions and the estimation of risk capital reserves supporting a portfolio of loans and credit derivatives requires the computation of the probability distribution of the future portfolio value. The distribution of portfolio value takes a complicated form because it takes account of losses from default, interest income, protection and default risk premia, and the mark-to-market volatility of the derivative positions. This paper develops an analytical approximation for this distribution. The approximation is based on a small-time expansion of a transform of the portfolio value. It applies to many standard intensity-based models of rm-by-rm default timing. Numerical results illustrate the approximation for the value at risk of a portfolio of loans with hedging positions in credit swaps.

Production and futures hedging with state-dependent background risk

This paper examines the production and futures hedging decisions of the competitive firm under output price uncertainty and with state-dependent background risk. We show that the firm's optimal production decision is independent of the underlying uncertainty and of the firm's risk attitude. We further show that the firm's optimal futures position is a full-hedge that completely eliminates the output price risk if either the background risk is state-independent, or the firm's utility function is quadratic. When the firm's preferences exhibit prudence, an under-hedge or an over-hedge is optimal should the magnitude of the background risk vary in a monotonic manner with changes in the realized state. When the prudent firm has access not only to the unbiased futures contracts but also to fairly priced options, we construct a reasonable example wherein the firm optimally includes the options in its hedge position. Hence, we offer a rationale for the hedging role of options, which is over and above that of futures, in the case of state-dependent background risk.

Why Do Investors Buy Structured Products? A Behavioral Finance Explanation

People trade for both cognitive and emotional reasons, and the high demand for structured products raises many questions. For example, the costs in the form of lost dividend payments (if the hedge position is lost, or the bonus level is exceeded) and possible expensive secondary markets are examples of such questions. A better understanding of the reasons for the demand (such as underlying preferences) can help to reduce the number of issues and decrease costs, which can increase the efficiency of the certificate market. Overall, the author provides both theoretical and empirical evidence to clarify the demand for structured products based on the findings of prospect theory. The value function, in particular, from prospect theory provides plausible explanations for why structured products are attractive to investors, as shown with the example of bonus certificates. For further research, other explanations based on behavioral finance could be analyzed, such as mental accounting or myopic loss aversion. Using macro data, the author shows that bonus certificates are frequently demanded, as expected based on the theoretical analysis. But analyzing aggregated data to test theoretical hypotheses in behavioral finance is always problematic. It would be interesting to run some further experimental procedures to test the investors’ decision-making process. <b>TOPICS:</b>Fixed income and structured finance, in portfolio management

The Exchange Rate Effect of Multi-Currency Risk Arbitrage

This paper documents how currency speculators trade when international capital flows generate predictable exchange rate movements. The redefinition of the MSCI world equity index in December 2000 provides an ideal natural experiment identifying exogenous capital flows of index tracking equity funds. Currency speculators are shown to front-run international capital flows. Furthermore, they actively manage the portfolio risk of their speculative positions through hedging positions in correlated currencies. The exchange rate effect of separate risk hedging is economically significant and amounts to a return difference of 3.6 percent over a 5 day event window between currencies with high and low risk hedging value. The results of the classical event study analysis are confirmed by a new and more powerful spectral inference isolating the high frequency cospectrum of currency pairs. The evidence supports the idea that international currency arbitrage is limited by the speculators' risk aversion.

Production and Hedging Decisions under Smooth Ambiguity Aversion

This paper considers production and hedging decisions of firms under ambiguous price risk. We display that the separation property and the full hedging theorem hold in the presence of ambiguity. We also determine the condition that ambiguity aversion increases optimal hedging position.

Direct Commercial Real Estate as an Inflation Hedge: Korean Evidence

We examine whether direct commercial real estate (CRE) is an inflation hedge using the Korean market. We find that Korean CRE shows shor-trun positive co-movement with both expected and unexpected inflation, indicating that CRE serves as a short-run inflation hedge. We also find that inflation and CRE prices move in the same direction over the long run as well indicating that CRE serves as a long run positive inflation hedge. On the other hand, we find that listed equity is a short-run negative hedge and a long run positive hedge. Therefore, we conclude that CRE is an asset class that is different from listed stock. Finally, while GDP and inflation appear to be the common factors driving Korean CRE markets and listed equity capital markets (ECM), ECM returns lead CRE returns, suggesting that value-relevant information flows into the ECM, then into CRE.

Comparative analysis of the hedging effectiveness for soybean using ols and bivariate Garch Bekk Model

Dynamic hedging effectiveness for soybean farmers in Rondonópolis (MT) with futures contracts of BM&amp;F-BOVESPA is calculated through optimal hedge determination, using the bivariate GARCH BEKK model, which considers the conditional correlations of the prices series, comparing the results with the minimum variance model effectiveness, calculated by OLS, the unhedged and the naïve hedge positions. The financial effectiveness of the dynamic hedge model is superior and can be used by farmers for several decision making purposes such as price discovery, hedging calibration, cash flow projections, market timing, among others.

Asset Allocation and Consumption Choices of the Representative Agent with External Habit Formation*

In this paper, we examine the asset allocation and consumption policy of the investor with habit formation, given a set of publicly available information. We use time-separable preferences as a benchmark for comparing decisions made by an agent with habit formation. We find that external habit combined with the available information plays a prominent role in both asset allocation and consumption choices for the agent with habit. Force of habit discriminates the consumption policy with habit formation from that with time-separable preferences. The influence of external habit is found to be more pronounced and economically substantial on consumption choice than on asset allocation. In addition, we find that the intertemporal hedging demand of the agent varies considerably depending on instruments used and the investment horizon. Moreover, augmented instrument variable sets guide the agent with external habit to adopt an intertemporal hedging position that is contrary to that taken by the agent with time-separable preferences; this might seem counterintuitive but might be sensible advice when business downturn is anticipated. The degree of time nonseparability accents the external habit on the consumption policy rather than the portfolio policy.