Asymmetric Effect of Basis on Dynamic Futures Hedging: Empirical Evidence from Commodity Markets

Abstract

Dynamic minimum variance hedge ratios (MVHRs) have been commonly estimated using Bivariate GARCH model that overlooks basis effect on the time-varying variance-covariance of spot and futures returns. This paper proposes an alternative specification of the BGARCH model in which the basis effect is incorporated for estimating MVHRs. Empirical investigation in commodity markets suggests that basis effect is asymmetric, i.e., positive basis has greater impact than negative basis on the variance and covariance structure. Both in-sample and out-of-sample comparisons of the MVHR performance reveal that the model with the asymmetric effect provides greater risk reduction than the conventional models, illustrating importance of the asymmetric effect when modeling joint dynamics of spot and futures returns and hence estimating hedging strategies.

Keywords: Dynamic hedging strategy, Asymmetric basis effect, Time-varying volatility and correlation of spot and futures returns

JEL Classification: G13, C32