AN ARCH ANALYSIS OF THE HEDGING PERFORMANCE OF IMMINENTLY MATURING FUTURES CONTRACTS

Hedge ratio estimation studies avoid estimating hedge ratios for imminently maturing futures contracts because of the maturity effect whereby futures price volatility increases as price uncertainty is resolved at contract expiration. This study first points out that a futures-price volatility increase is neither necessary nor sufficient for reduced hedging effectiveness because hedging effectiveness depends on the cash-futures price correlation. To analyze the hedging performance of imminently maturing futures contracts risk is defined as the conditional variance of profit outcomes. The conditional mean is modeled as Brownian motion. This model was fit to cash and futures price data for corn, cotton, feeder cattle, soybeans, soybean oil, and soybean meal using daily observations from January 1990 through mid-March 2002. Test results indicate that daily futures prices for these commodities follow a random walk while spot prices are predictable. Therefore, zero (for futures prices? and the predicted value (for spot prices) were used as the conditional means in estimating the conditional variances for futures and spot prices. Volatility is analyzed as an ARCH process with a mean that follows a quadratic function of days to maturity. It was found that the quadratic function was significant for all futures contracts with the volatility minimum occurring between 131 and 259 days before contract maturity. The ARCH effects were generally not significant for futures prices while spot price volatility displayed significant ARCH effects. The maturity effects in the futures markets has a dominant influence on the spot-futures correlation so that the effectiveness of hedging tends to decrease as the futures price volatility begins to increase. The effectiveness decline occurs far sooner than the contract selection rules imply.