Application of polynomial projection ensembles to hedging crude oil commodity risk

Although the rapid expansion in derivative market in previous decades has drawn research in both theory and practice of hedging against commodity risk, recent volatile fluctuations in crude oil prices in world market have renewed profound interest in examination of existing and development of new hedging models and strategies. In this paper, we propose and develop a methodological framework for applying individual and ensembles of polynomial projection models to hedge against oil commodity price risk. The study also comparatively evaluates the hedging performances of these projection models and benchmarks them against naïve hedging, VEC–GARCH model, and the case of no hedging. In addition, the empirical analysis considers a trader’s level of risk aversion in commodity hedging as well as the adoption of transaction cost. Our findings indicate promising out-of-sample hedging capability by polynomial projection models. Also, different forms of integrated ensembles of projections outperform individual polynomial projections, suggesting the usefulness of ensemble structure in enhancement of hedging in an uncertain environment.

► We use polynomial projection models to hedge against oil commodity price risk. ► Individual and ensembles of projection and other hedging models are compared. ► Transaction costs and risk aversion are considered. ► Empirical analysis shows promising hedging capability by projection models. ► Ensemble models perform better than individual models.