The volatility race in Commodities : The optimal hedge ratio in Copper, Gold, Oil and Cotton

• Main Authors: Haglund, Fredrik, Johan, Svensson
• Format: Others
• Language: English
• Published: Internationella Handelshögskolan, Högskolan i Jönköping, IHH, Företagsekonomi 2005
• Subjects: commodities; hedging; optimal hedge ratio; futures; Oil; Copper; Cotton; Gold; Business studies; Företagsekonomi
• Online Access: http://urn.kb.se/resolve?urn=urn:nbn:se:hj:diva-88

Introduction: Companies that are dependent on different commodities as input or output are exposed to price risk in these commodities. The price changes can be expressed as volatility and higher volatility results in higher risk. Hedging the commodity contracts with futures can offset this risk. One of the most important questions in this field is to what extent the risk exposure should be hedged with futures contract, i.e. the optimal hedge ratio. Purpose: The study aims to conduct an analysis of the variance in different commodities contracts and provide evidence of the optimal hedge ratio in the respective commodities. Method: We used a quantitative study with daily spot and futures price changes of Copper, Gold, Cotton and Oil. We investigated the 6-month hedging behaviour where timeseries were created for the period January-June each year during 2001-2004. We used a simple linear regression of the futures and spot price changes and a minimum variance model in order to calculate the optimal hedge ratio. Conclusion: Companies that are dependent on Copper, Gold, Cotton and Oil can significantly reduce the risk by engaging in futures contracts. The optimal hedge ratio for Copper is (96%), Gold (52%), Cotton (96%) and Oil (88%). By applying the optimal hedge ratio, a company may reduce their risk exposure up to 90% compared to an unhedged position.