Hedging Positions Research Articles

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

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

Production and hedging under state‐dependent preferences

AbstractThis study examines the behavior of the competitive firm under output price uncertainty and state‐dependent preferences. When there is a futures market for hedging purposes, the firm's optimal production decision is independent of the output price uncertainty and of the state‐dependent preferences. If the futures contracts are unbiased, the firm's optimal futures position is an over‐hedge or an under‐hedge, depending on whether the firm is correlation averse or correlation loving, and on whether the output price is positively or negatively expectation dependent on the state variable. When the firm has access not only to the unbiased futures but also to fairly priced options, sufficient conditions are derived under which the firm's optimal hedge position includes both hedging instruments. This study thus establishes a hedging role of options, which is over and above that of futures, in the case of state‐dependent preferences. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark 32:945–963, 2012

기계학습과 동적델타헤징을 이용한 옵션 헤지 전략

동적 델타 헤징(Dynamic Delta Hedging)이란 옵션 발행자가 옵션의 만기정산금액(payoff)을 지급하기 위해 주기적으로 델타에 근거한 헤지 포지션을 조절함으로써 옵션의 payoff를 복제하고 옵션 가치변화에 따른 위험을 회피하는 방법이다. 본 연구에서는 헤지에 있어서 주요 변수인 블랙-숄즈의 모형에 의해 산출된 델타의 대체 값을 찾기 위해 기계학습의 일종인 인공신경망 학습을 적용하여 옵션의 만기 시 헤지 비용의 최소화 및 차익 실현을 위한 방법론을 제시하고자 한다. 기초자산의 현재가격, 변동성, 무위험이자율, 만기 등의 시장 상황 변화에 따른 다양한 시나리오에 대한 실험을 통해 본 연구에서 제시하는 방법론의 성능을 분석하고 그 우수성을 보인다. Option issuers generally utilize Dynamic Delta Hedging(DDH) technique to avoid the risk resulting from continuously changing option value. DDH duplicates payoff of option position by adjusting hedge position according to the delta value from Black-Scholes(BS) model in order to maintain risk neutral state. DDH, however, is not able to guarantee optimal hedging performance because of the weaknesses caused by impractical assumptions inherent in BS model. Therefore, this study presents a methodology for dynamic option hedge using artificial neural network(ANN) to enhance hedging performance and show the superiority of the proposed method using various computational experiments.

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 the 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.

The Impact of Price-Induced Hedging Behavior on Commodity Market Volatility

The utility maximization problem of a grain producer is formulated and solved numerically under prospect theory as an alternative to expected utility theory. Conventional theory posits that the optimal hedging position of a producer is not affected solely due to changes in the level of futures prices. However, a strong degree of positive correlation is apparent in the data. Our results show that with prospect theory serving as the underlying behavioral framework, the optimal hedge of a producer is affected by changes in futures price levels. The implications of this price-induced hedging behavior on spot prices and volatility are subsequently considered.

Evaluation of static hedging strategies for hydropower producers in the Nordic market

In this paper we develop an optimization model to derive static hedge positions for hydropower producers with different risk characteristics. Previous research has primarily considered dynamic hedging; however, static hedging is the common choice among hydropower producers because of its simplicity. Our contribution is to evaluate such hedging out of sample. The hedging strategies we analyze include a natural hedge, which means no hedging, and output from an optimization model that we develop ourselves. The results show that, although optimized positions vary over time, hedging with the use of forward contracts significantly reduces the risk in terms of value-at-risk, conditional value-at-risk and standard deviation of the revenue. Furthermore, this improvement results in only a minor reduction in mean revenue.

Accounting‐Based Probabilistic Prediction of ROE, the Residual Income Valuation Model and the Assessment of Mispricing in the Swedish Stock Market

Using Swedish stock market data, this study investigates whether an investment strategy based on publicly available accounting information can generate abnormal investment returns. The strategy involves two steps. First, an accounting‐based probabilistic prediction model of changes in the medium‐term book return on owners' equity (ROE) is estimated. Second, market expectations of changes in medium‐term ROE are assessed through observed stock prices and the residual income valuation model. Stock market positions over 36‐month holding periods are taken when the accounting‐based predictions of ROE and the market expectations differ. Over the period 1983–2003, the investment strategy generated values of Jensen's alpha corresponding to an average monthly excess return for a hedge position of up to 0.8% for a sample of manufacturing companies. In the main this hedge return was caused by strong positive returns to the long positions, and additional analyses show that the returns appear to have been affected by a positive market sentiment bias (i.e., positive ROE surprises being associated with stronger price reactions than negative ROE surprises) making out‐of‐sample inferences somewhat dubious. Furthermore, most of the investment returns accrued over holding periods up to around 1995, with no indications of market mispricing over the last third (1995–2003) of the investment period. The empirical results are consistent with market investors having become more sophisticated in their use of publicly available accounting information over time.

Do Investors Understand Really Dirty Surplus?

ABSTRACT: This study addresses whether firms’ share prices correctly reflect two accounting measures: dirty surplus and really dirty surplus. Dirty surplus is readily observable from the financial statements, but really dirty surplus, which arises from recognizing equity transactions such as employee stock option exercises at other than fair market value, is not. Findings show that dirty surplus and really dirty surplus are irrelevant for forecasting abnormal comprehensive income. However, findings also indicate that investors appear to undervalue really dirty surplus. Hedge returns are insignificant when portfolios are formed based on dirty surplus, but are significantly positive based on really dirty surplus. Really dirty surplus positive hedge returns are robust to a variety of sensitivity tests. Taken together, the findings are consistent with either investors over-valuing firms that have large negative really dirty surplus or really dirty surplus being correlated with an unmodeled risk factor.

Stock 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.

Do Investors Understand Really Dirty Surplus?

This study addresses whether firms’ share prices correctly reflect two accounting measures, dirty surplus and really dirty surplus. Dirty surplus is readily observable from the financial statements, but really dirty surplus, which arises from recognizing equity transactions such as employee stock option exercises at other than fair market value, is not. Findings show that dirty surplus and really dirty surplus are irrelevant for forecasting abnormal comprehensive income. However, findings also indicate that investors appear to undervalue really dirty surplus. Hedge returns are insignificant when portfolios are formed based on dirty surplus, but are significantly positive based on really dirty surplus. Really dirty surplus positive hedge returns are robust to a variety of sensitivity tests. Taken together, the findings are consistent with either investors overvaluing firms that have large negative really dirty surplus or really dirty surplus being correlated with an unmodeled risk factor.

Pricing and hedging of quanto range accrual notes under Gaussian HJM with cross‐currency Levy processes

AbstractThis study analyzes the pricing and hedging problems for quanto range accrual notes (RANs) under the Heath‐Jarrow‐Morton (HJM) framework with Levy processes for instantaneous domestic and foreign forward interest rates. We consider the effects of jump risk on both interest rates and exchange rates in the pricing of the notes. We first derive the pricing formula for quanto double interest rate digital options and quanto contingent payoff options; then we apply the method proposed by Turnbull (Journal of Derivatives, 1995, 3, 92–101) to replicate the quanto RAN by a combination of the quanto double interest rate digital options and the quanto contingent payoff options. Using the pricing formulas derived in this study, we obtain the hedging position for each issue of quanto RANs. In addition, by simulation and assuming the jump risk to follow a compound Poisson process, we further analyze the effects of jump risk and exchange rate risk on the coupons receivable in holding a RAN. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:973–998, 2009

Enhancing FX Risk Management with Inflation and Interest Rate Derivatives

Firms that export goods face risks such as product price, cost, and exchange rate risks. Price and cost risks can substantially reduce the FX hedging performance in real wealth. Thus, hedging strategies that are supposed to improve the performance of the FX hedge in real terms using inflation and interest rate derivatives are investigated. The behavior of these additional instruments is not obvious at first sight and has not been presented in the hedging literature so far. For this purpose, variance-minimizing hedge positions of an exporting firm are derived. A cointegrated VAR and bootstrap methods are used to evaluate the efficiencies of several hedging strategies. While inflation derivatives work better in the short run, interest rate derivatives perform better over longer hedge horizons.

The Term Structure of Currency Hedge Ratios

Many firms face product price risk in foreign currency, uncertain costs in home currency and exchange rate risk. If prices and exchange rates in different countries interact, natural hedges of foreign exchange risk might result. If the effectiveness of such hedges depends on the hedge horizon, they might affect a firm's usage of foreign exchange derivatives and lead to a term structure of optimal hedge ratios. We analyze this issue by deriving the variance minimizing hedge position in currency forward contracts of an exporting firm that is exposed to different risks. In an empirical study, we quantify the term structure of hedge ratios for a ' typical ' German firm that is exporting either to the United States, the United Kingdom or Japan. Based on cointegrated vector autoregressive models of prices, interest rates and exchange rates, we show that the hedge ratio decreases substantially with the hedge horizon, reaching values of one half or less for a ten-years horizon. Our findings can (partly) explain the severe underhedging of long-term exchange rate exposures that is frequently observed and have important implications for the design of risk management strategies.

Dérivés et comptabilité de couverture en IFRS : vers une (mé)connaissance des risques ?

Face a la sophistication de la gestion des societes dans un monde plus globalise, la connaissance de l’exposition reelle des risques qu’elles encourent est devenue cruciale, tant pour la gestion des societes elles-memes que pour les acteurs en relation avec elles (agences de notation, analystes financiers, actionnaires, creanciers, salaries...). Parallelement, la technicite des instruments derives et leur volume croissant dans le bilan des entreprises, a necessite une evolution des normes comptables internationales qui s’inscrit dans un souci de transparence. Leur objectif est que les comptes offrent une image fidele de la solidite bilantielle de chaque societe ; afin non seulement de les inciter a mieux gerer leurs risques, mais aussi d’apporter toute la connaissance exigee par les utilisateurs des etats financiers. Dans une premiere partie, nous analysons le traitement comptable des derives par l’IAS 39. Nous montrons que les solutions proposees par les IFRS (y compris la comptabilite de couverture) vont a l’encontre de leurs objectifs d’image fidele et de meilleure gestion des risques, compte tenu de la volatilite excessive qu’elles engendrent dans le compte de resultat. Qui plus est, cette volatilite est totalement deconnectee de l’exposition reelle de l’entreprise. Dans une seconde partie, notre analyse de l’impact des choix comptables retenus par le normalisateur international quant a la comptabilisation des couvertures, sur la perception des risques a travers les etats financiers et les consequences en termes de comportements de gestion financiere, est etayee en nous appuyant sur les travaux de la litterature academique theorique et empirique. Nous montrons ainsi que la volatilite comptable sur le compte de resultat (meme si elle ne represente en aucun cas, la volatilite economique et donc l’exposition reelle des societes) modifie la perception du risque par les marches financiers. Cette augmentation artificielle des risques est source de modification des comportements des entreprises. Les impacts sur la gestion financiere ne sont ni optimaux d’un point de vue financier, ni en adequation avec les objectifs des IFRS.

Optimization-Based Generation Asset Allocation for Forward and Spot Markets

One of the most important daily decisions that a Genco has to make is to allocate generation assets between the forward and spot markets. That is, how much capacity should be contracted in the forward market and how much should be kept to bid in spot market? This paper focuses on generation asset allocation between monthly forward contracts, such as bilateral contracts, futures contracts, options contracts, and daily spot markets, considering operating costs and constraints of generating units, as well as spot price risk. The problem is to find the optimal hedging position based on the known forward price and the forecasted hourly spot prices and is formulated based on the model of PJM market. The double dynamic programming method is applied to solve this optimal asset allocation problem with all the short-term operating constraints of the generating unit satisfied. Three types of forward contracts that are commonly used in practice are considered and their impact on generation asset allocation are analyzed and compared. The analytic relationship between the optimal contract quantity of a particular type and spot generation is established. Based on this relationship, the applicability and characteristics of a particular type of contract are discussed. Furthermore, with the solution to the generation asset allocation problem as a basis, the pricing strategy in the forward market is analyzed. A Nash game model is established and an iterative process is developed to determine the equilibrium pricing of futures contracts. Numerical testing shows that the method for the generation asset allocation is effective. Various factors influencing the decision of generation asset allocation and the relationship between futures contract price and spot price are tested and analyzed.

Financial Statement Information, the Prediction of Book Return on Owners' Equity and Market Efficiency: The Swedish Case

Abstract: Using Swedish data, this study investigates whether financial statement information can be used to predict changes in the medium‐term book return on owners' equity and subsequently evaluates the performance of trading strategies based on such predictions. A univariate prediction model based on the past book return has higher prediction accuracy than more elaborate models that include additional accounting numbers. The main trading strategy generates a hedge position return of 29% over a three‐year holding period. Interestingly, most of the return is attributable to the long position. However, the results are found to be sensitive to the choice of return metric.

Portfolio optimization with CVaR under VG process

Formal portfolio optimization methodologies describe the dynamics of financial instruments price with Gaussian Copula (GC). Without considering the skewness and kurtosis of assets return rate, optimization with GC underestimate the optimal CVaR of portfolio. In the present paper, we develop the approach for portfolio optimization by introducing Lévy processes. It focuses on describing the dynamics of assets’ log price with Variance Gamma copula (VGC) rather than GC. A case study for three Indexes of Chinese Stock Market is performed. On application purpose, we calculate the best hedge positions of Shanghai Index (SHI), Shenzhen Index (SZI) and Small Cap Index (SCI) with the performance function CVaR under VG model. It can be combined with Monte Carlo Simulation and nonlinear programming techniques. This framework is suitable for any investment companies.

Forging a Sino-US “grand bargain” in space

Sino-US competition, and even conflict, in space seems increasingly likely in light of recent anti-satellite events. Advancing the cause of non-weaponization of space has long been limited by the scope of discussions. This article recommends to the incoming US administration a bargaining strategy that encompasses wider issues, increasing the possibility of circumventing this impasse and achieving improved security for US space systems by forestalling an anti-satellite arms race. Including commercial space and civil space issues in discussions with China on space security, in a type of “grand bargain” negotiation, may lead to agreement between the parties on a code of conduct in space. Simultaneously taking certain hedging positions against default may improve the US bargaining position and increase the likelihood of compliance.

A Multirisk Approach to Measuring Corporate Hedging and its Determinants

The willingness of a firm to hedge its activities is difficult to measure. A single indicator for the use of derivatives or even the notional or fair value of its hedging positions have been shown to entail limitations. In this paper, we introduce a new measure based on the number of risks hedged. From the US EDGAR database, we extract information on the hedging activity in four types of risks: interest rate, currency, commodity and equity. This allows us to better test the theoretical determinants of hedging. In a sample of firms from the S&P 500 over the period 2001 to 2005, we study the hedging behavior by industry and type of risk. While we confirm that leverage, foreign sales and size are the main empirical determinants for corporate hedging, we find significant variations across industries. We also provide empirical support for other determinants such as dividend policy, liquidity, tax credits, growth opportunities and managerial shareholdings. Confirming Adam, Dasgupta and Titman (2007) prediction, we observe that hedging policy heterogeneity is positively related to the competitive structure of the industry.

Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers

The literature on corporate risk management has traditionally assumed that derivative securities are fairly priced, and thus disregarded the possibility that non-financial firms might use derivatives to generate positive returns by exploiting market conditions. This premise has led researchers to rationalize corporate risk management by its beneficial effects on bankruptcy costs and taxes, debt capacity, cost of capital, underinvestment costs, and managerial risk aversion. Our study questions this fundamental premise and thereby makes two principal contributions. First, we show that the assumption that derivatives contracts are fairly priced on average can be violated for an extended period. By studying the hedging activities of a sample of North American gold mining companies over the 1989-1999 period, we find that these firms generated significant excess cash flows by selling gold forward. Our sample firms realized an average total cash flow gain of $11 million or $24 per ounce of gold per year, while their average annual net income was only $3.5 million. The source of these gains is a persistently positive spread between contracted forward prices and realized spot prices. This finding highlights a new motive for the corporate use of derivatives and a new potential source of value associated with risk management that the literature has previously ignored. Second, and in contrast to our first contribution, we show that firms do not realize economically significant cash flow gains by trying to time the market in their use of derivatives. Market-timing in the context of hedging programs is a form of speculation. We find considerable evidence in our sample that managers respond to changing market prices by varying the sizes of their hedge positions, and that this variation is far in excess of what can be explained by changes in a firm's fundamentals. However, these attempts to time the market do not yield positive cash flows on average. We conclude that managers in our study have no market-timing ability and speculating in this way creates no value (and probably destroys value) for shareholders. This finding is in stark contrast to a widely-held view among many corporate executives that market timing should be an integral part of any hedging program.