Management Working Papers School of Management Short-run deviations and time-varying hedge ratios: evidence from agricultural futures markets

This paper investigates the hedging effectiveness of time-varying hedge ratios in the agricultural commodities futures markets based on four different versions of the GARCH models. The GARCH models applied are the standard bivariate GARCH, the bivariate BEKK GARCH, the bivariate GARCH-X and the bivariate BEKK GARCH-X. The GARCH-X and the BEKK GARCH-X models are uniquely different from the other two models because they take into consideration the effect of the short-run deviations from the long-run relationship between the cash and futures prices on the second conditional moments of the bivariate distribution of the variable. For comparison, a constant minimum variance hedge ratio estimated by means of OLS is also applied. Futures data for corn, coffee, wheat, sugar and soybean are applied. Comparison of the hedging effectiveness is done for the within sample period (1980-2004), and two out-of-sample periods (2002-2004 and 2003-2004) performance. Results indicate superior performance of the portfolios based on the GARCH-X model estimated hedge ratio during most periods. 1 The author thanks an anonymous referee and the editor of this journal for valuable comments and suggestions. The author also thanks the participants of the European Financial Management Association conference 2006 Madrid, Spain for valuable comments and suggestions on an earlier draft of the paper. Any remaining errors and omissions are the author's responsibility alone.