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 Hedging Crude Oil and Corn Futures: An Application in

International Trade

Xin Li1

Selected Poster prepared for presentation at the Agricultural & Applied Economics
Association’s 2014 AAEA Annual Meeting, Minneapolis, MN, July 27-29, 2014.

Copyright 2014 by Xin Li. All rights reserved. Readers may make verbatim copies of
this document for non-commercial purposes by any means, provided that this
copyright notice appears on all such copies.

1
Xin Li is a PhD student in the Department of Agricultural and Consumer Economics, University of Illinois at
Urbana-Champaign. Correspondence can be directed to Xin Li. Postal address: 1301 W. Gregory Dr., Urbana, IL
61801, Email: xinli4@[Link].
 Hedging Crude Oil and Corn Futures: An Application in International Trade
Xin Li, PhD Student
Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign (xinli4@[Link])

INTRODUCTION ECONOMETRIC ESTIMATION The Spot and Futures Market Prices Monthly Average Hedge Performance Daily Average Hedge Performance
(Financial Crisis of 2007-2008) (Financial Crisis of 2007-2008)
Purpose
• VECM
• Corn and crude oil futures contracts are ∆pt = 𝑐 + Π𝑝𝑡−1 + ΓΔ𝑝𝑡−1 + 𝑢𝑡 Utility Variance Effectiveness (%) Utility Variance Effectiveness (%)
analyzed for their effectiveness in reducing = 𝑐 + αβ ⊺ 𝑝𝑡−1 + ΓΔ𝑝𝑡−1 + 𝑢𝑡 Unhedged -692.7047 15915.13449 -
uncertainty for international corn traders Unhedged -727.0452 14067.0037 -
after China’s accession to the World Trade Portfolio 1: using only corn futures contracts Portfolio 1: using only corn futures contracts
Organization. • DCC MGARCH Model Naïve -701.3631 15154.7671 4.7776
pt = 𝜇𝑡 + 𝑢𝑡 Naïve -727.5433 14027.1098 0.2836
• Use crude oil prices (used as proxy for bunker OLS -701.3242 15145.8803 4.8334
1
fuel costs) for transportation costs under a OLS -727.541 14026.8492 0.2854
𝑢𝑡 = 𝐻𝑡 𝑧𝑡 2
cross-market price dynamics framework. VECM-DCC-MGARCH -701.422 15169.1492 4.6872 VECM-DCC-MGARCH -727.5525 14028.2942 0.2751
Portfolio 2: using both futures contracts: corn and oil Portfolio 2: using both futures contracts: corn and oil
Ht = 𝐷𝑡 𝑅𝑡 𝐷𝑡
Previous Findings Naïve -672.838 10844.2856 31.8618 Naïve -725.8237 13952.2635 0.8156
• time-varying covariability between different OLS -672.9272 10849.3889 31.8297
yet related markets (corn and crude oil) in a MOTIVATION OLS -725.8294 13951.5784 0.8205

multiple risk environment. VECM-DCC-MGARCH -672.1316 10880.7847 31.6324 VECM-DCC-MGARCH -726.1999 13939.5331 0.9061
• The cross-hedge quality of index futures and Correlations of Variables
forward freight agreements are extremely • During financial crisis period, market estimates • The cross hedging effectiveness have increased
limited, which resulted in historically low
(C) (c)
Full Sample Period
(O) (o) (e) (G) (P) (B) of implied volatility of prices increased considerably compared to traditional hedging in CONCLUSIONS
levels of trading and consequently, makes a dramatically corn futures markets alone.
corn cash (C) 1
simple hedging of futures contracts corn futures • In general, hedging effectiveness is increasing in • The naïve hedge strategy is compared to the
impossible.
• Thus, one must employ an alternate
(c) 0.997 1 RESULTS hedging horizon. OLS hedge ratio estimation and the VECM-
DCC-multivariate-GARCH method.
oil cash (O) 0.818 0.803 1
approach (e.g., using crude oil futures) oil futures (o) 0.814 0.798 0.999 1 Monthly Average Hedge Performance Daily Average Hedge Performance • Explicit modeling of the time-varying in hedge
USD/RMB (e) 0.910 0.898 0.811 0.812 1 (Full Sample) (Full Sample) ratios using all derivatives, and taking into
HEDGING MODEL Gulf to Japan
(G) 0.297 0.312 0.348 0.342 0.200 1
account dependencies between different, yet
related markets, results in reduction in risk
PNW to 1 Utility Variance Effectiveness (%)
Japan(P) 0.163 0.167 0.240 0.233 0.057 0.910 Utility Variance Effectiveness (%) especially during financial crisis period.
• The hedged outcome at time t for the trader BDI (B) -0.098 -0.087 0.005 0.117 -0.218 0.870 0.931 1 Unhedged -520.1704 38267.4583 - • This process can be replicated on the U.S.
Unhedged -529 37047.28004 - Portfolio 1: using only corn futures contracts
is determined as: Recession Period (Dec. 2007- Jun. 2009) export traders, which remain without suitable
Portfolio 1: using only corn futures contracts Naïve -520.2842 38242.1491 0.0661
corn cash (C) 1 commodity-specific export indices to provide
corn futures Naïve -531.1756 36555.7574 1.3267
Wt = −Ct et − Ot et OLS -520.284 38242.1882 0.0660 the foundation for new contracting
(c) 0.995 1 OLS -531.1709 36555.2985 1.3279 methodologies and hedging instruments.
+b1 ct et − ct−1 et + b2 ot et − ot−1 et oil cash (O) 0.911 0.921 1 VECM-DCC-MGARCH -520.4068 38215.6754 0.1353
oil futures (o) 0.917 0.927 0.998 1 VECM-DCC-MGARCH -531.1802 36547.9953 1.3476 Portfolio 2: using both futures contracts: corn and oil
USD/RMB (e) -0.026 -0.050 -0.260 -0.237 1 Portfolio 2: using both futures contracts: corn and oil
• The minimum variance hedge ratios collapse
to the traditional OLS hedge ratios: Gulf to Japan Naïve -527.96 36974.9826 0.1951
Naïve -520.119 38335.7995 -0.1785 ACKNOWLEDGEMENTS
(G) 0.800 0.817 0.937 0.932 -0.474 1
bt−1 h21t PNW to 1 OLS -527.9698 36967.0607 0.2165 OLS -520.1195 38334.9772 -0.1764
= 22 Japan(P) 0.768 0.785 0.915 0.909 -0.557 0.974 Dr. Paul Peterson, Dr. Philip Garcia, Xiaoyang Wang,
qt−1 ht
BDI (B) 0.718 0.747 0.884 0.878 -0.580 0.975 0.977 1 VECM-DCC-MGARCH -527.5866 37025.9951 0.0574 VECM-DCC-MGARCH -520.2798 38276.7313 -0.0242 Lei Yan, Jay O’Neil, O’Neil Commodity Consulting
RESEARCH POSTER PRESENTATION DESIGN © 2012

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