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.

► We examine the effectiveness of minimum-variance hedging on crack spread spot positions using futures ► Hedge ratios are derived using popular econometric methods found in the literature: OLS, EWMA, GARCH ► Our analysis takes account of margin and transaction costs involved in trading commodity futures ► None of the advanced minimum-variance hedging models are able to significantly outperform the 1:1 naïve hedge ► Investors are encouraged to use the naïve hedge over minimum-variance hedges to avoid excessive hedging costs