The use and abuse of the hedging effectiveness measure

Ederington (1979) proposed an effectiveness measure for futures hedging. Since then, this measure has been widely adopted in the literature to compare different hedge ratios against the OLS (ordinary least squares) hedge ratio. This note attempts to demonstrate this application is inappropriate. Ederington hedging effectiveness is only useful for measuring the risk reduction effect of the OLS hedge ratio. It does not apply to other hedge ratios and therefore should not serve as a criterion to compare different hedge strategies against the OLS strategy. A strict application of this measure almost always leads to an incorrect conclusion stating that the OLS hedge ratio is the best hedging strategy.