Risk Minimizing Hedging of Crude-Oil Options: Theory and Empirical Performance

35 Pages Posted: 25 May 2011 Last revised: 27 Jul 2011

See all articles by Christian Oliver Ewald

Christian Oliver Ewald

University of Glasgow; Høgskole i Innlandet

Roy Nawar

University of Sydney

Tak-Kuen Siu

Macquarie University, Macquarie Business School

Date Written: May 16, 2011

Abstract

We study the hedging problem for European-style options written on crude-oil futures. Locally risk-minimizing hedging strategies are derived under the assumption that the dynamics of crude-oil futures are described by a Merton-type jump-diffusion. These are then tested empirically using historical data from the NYMEX West Texas Intermediate (WTI) from the 2002-2007 period. We use Black-Scholes-Merton delta hedges as a benchmark for comparison and find that in crude-oil option markets locally risk-minimizing hedges systematically outperform the benchmark by a margin of 13%-18%. In addition to this real world performance test, we also investigate hedging strategies for robustness against model uncertainty and mis-specification, using simulated data. Our results show that locally risk minimizing strategies are much more robust than its classical alternatives.

Keywords: Risk-minimizing hedging, crude-oil options, futures, energy derivatives, resource economics

JEL Classification: Q40, G11, C44

Suggested Citation

Ewald, Christian Oliver and Nawar, Roy and Siu, Tak-Kuen, Risk Minimizing Hedging of Crude-Oil Options: Theory and Empirical Performance (May 16, 2011). Available at SSRN: https://ssrn.com/abstract=1843235 or http://dx.doi.org/10.2139/ssrn.1843235

Christian Oliver Ewald

University of Glasgow ( email )

Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom

Høgskole i Innlandet ( email )

Lillehammer, 2624
Norway

Roy Nawar (Contact Author)

University of Sydney ( email )

University of Sydney
Sydney, NSW 2006
Australia

Tak-Kuen Siu

Macquarie University, Macquarie Business School

New South Wales 2109
Australia

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