Downside risk and the energy hedger's horizon

a r t i c l e i n f o In this paper, we explore the impact of investor time-horizon on an optimal downside hedged energy portfolio. The optimal heating oil hedge ratio is first calculated for a variety of downside risk objective functions at different time-horizons using the wavelet transform. Next, associated hedging effectiveness is contrasted for a range of risk metrics, with all metrics showing increasing hedging effectiveness at longer horizons. Moreover , decreased hedging effectiveness is demonstrated for increased levels of uncertainty at higher confidence intervals. While small differences in effectiveness are found across the different hedging objectives, time-horizon effects are found to dominate confirming the importance of the hedging horizon. The findings suggest that while downside risk measures are useful in determining an optimal futures hedge encompassing negative returns, hedging horizon and confidence intervals should also be given careful consideration by the energy hedger. The practice of risk management often involves the use of futures contracts to manage the price risk associated with a given spot market position. The optimal futures hedge ratio necessary to reduce the risk associated with a given spot position is commonly determined using variants of the minimum-variance approach (Brooks et al., 2002; Chen et al., 2003). However, the minimum-variance approach treats positive and negative fluctuations equally, while hedgers may prioritize the reduction of downside risk only Hung and Lee, 2007. Another important hedging consideration is the horizon over which a hedger wishes to reduce risk, with improved effectiveness found for longer horizons (Ederington, 1979). However, these and other studies have only considered the impact of the hedging horizon on the minimum-variance hedge ratio (for example, In and Kim, 2006). In this study, we build on the previous literature by considering the effect of the hedging horizon on both the optimal futures hedge ratio and associated effectiveness for a variety of downside risk hedging objectives. The primary aim of corporate risk management is to provide protection against the possibility of dangerous tail-risk events (Stulz, 1996). In the context of futures hedging, a range of alternative downside risk measures have been proposed to estimate and subsequently limit the impact of low probability tail-risk events. 2 Value-at-risk (VaR) and conditional value-at-risk (CVaR or expected shortfall) are two approaches to measure potential loss of a portfolio over a given period 3 and have been applied as risk objectives in a portfolio allocation setting (Adam …