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Asymmetric effect of basis on dynamic futures hedging: Empirical evidence from commodity markets

By Donald Lien and Li Yang

Abstract

The dynamic minimum variance hedge ratios (MVHRs) have been commonly estimated using the Bivariate GARCH model that overlooks the basis effect on the time-varying variance-covariance of spot and futures returns. This paper proposes an alternative specification of the BGARCH model in which the effect is incorporated for estimating MVHRs. Empirical investigation in commodity markets suggests that the basis effect is asymmetric, i.e., the positive basis has greater impact than the negative basis on the variance and covariance structure. Both in-sample and out-of-sample comparisons of the MVHR performance reveal that the model with the asymmetric effect provides greater risk reduction than the conventional models, illustrating importance of the asymmetric effect when modeling the joint dynamics of spot and futures returns and hence estimating hedging strategies.

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