In my research I try to find to most effective method of estimating Hedge Ratio using Futures and Forwards in commodities market using different methods of estimation. The question is: " How can I explain a negative hedge ratio?"
Is it short selling or something?
I look forward to listen to your opinions.
Since the h(S) is the stock price rate. A negative imply a falling price. In the action of managing money. You may opt to give-out every thing or some of you stocks earlier than later. Because, regime of the price may be a broblem to figure it out how long will it's be in the market. Possible, if you don't own any stocks, this is a chance to short sell. Adverse effects could arise of the ratio estimation or report does not follow with the market. This could be a non- systemic error as the company stock risk, in the market that is moving or too large to accuracy predicts. If you hold no stock's, then trade as an arbitraguer. Trade insurance, the simple margin account is valid to protect your moneyless trade by shortselling. Most commonly if you hold stock you need value the market occurrences, by selling call at some low price not lower than expected. Either buy put option to sell at some known price now.
To protect a position, in which you have for example a number of stocks (a long position), you can build a hedge ratio, which tells you the amount you should invest in other asset that has an opposite behavior (or at least not positively correlated) with the stocks.
You must have a short position in that asset, so if the stock price falls, the price of this asset will go up. Then the value of the portfolio composed of the stock and the asset is less affected by the fall in the price of the shares.
This is the reason why the hedge ratio should generally have a negative sign.
Dear Michael Tsatsaronis:
Given that you are dealing with commodities, the basic way to define a Hedge Ratio (HR) for any asset is as follows:
HR = [ Value of Commodity Portfolio to be Hedged in Monetary Terms ($) X Systematic Risk Factor (Beta factor) ] / [ Value of the Future Contract on Commodity (or Commodity Index) in Monetary Terms ($) ]
Since you are dealing with a portfolio of commodities, you can estimate the systematic risk factor (beta factor) of your portfolio by estimating the slope of the regression line of your portfolio against a “representative” commodity index.
In addition, Value of the Future Contract in Monetary Terms ($ ) = The Value of the Future Contract in the Market X Convertor or Multiplier in $.
The typical case, is that you have a long position in the commodities and you would like to hedge your market exposure because of the possibility of downside risk.
In this case, the HR tells you the number of contracts that You Need to Short (i.e., the number of contracts to sell in the future markets). In other words, you need to take a short position on the future contact.
If your portfolio of commodities includes Many Assets, then you need to select a Forward contract or a Future contract on a commodity index.
Alternatively, you can use Cross-Hedging by selecting a community future contact that has the highest correlation factor with your commodity portfolio.
Best Regards
Prof. Dr. Mazin A. M. Al Janabi
Full Professor of Finance & Banking and Financial Engineering
Tecnologico de Monterrey, EGADE Business School,
Santa Fe Campus, Mexico City, Mexico.
The sign of hedging ratio shows the position in your portfolio. For instance, negative hedging ratio means that you should take a short position.
Thank you all for your answers!
You can also have a look at my project
https://www.researchgate.net/project/Hedge-Ratio-estimation-method-for-Commodity-Markets
and have your opinions.
My friendly regards
MIke
In Commodities ideally you have to hedge using right (closest) maturity and ideally type. E.g. your portfolio contains Brent oil and you hedge using WTI contracts, you are running into basis risk (commodity has location and quality as parameters). Next you have to do it using liquid contracts, unless you want to accept physical delivery and deliver yourself certain commodity into predefined location. Next agricultural commodities are totally different from metals and oil in terms of liquidity. You have to know what you are doing. It is not S&P 500. i.e. Electricity futures may not be available in some markets and prices of electricity in one location has nothing to do with prices in another one.