The Hedging Effectiveness of Futures and Options

Abstract

The major economic benefit provided by futures and options market is risk management through hedging. Extensive literature in futures hedge focused on the application of mean-variance analysis of Markowitz portfolio selection theory. As is well known, mean-variance analysis is based on the assumption that either returns are normally distributed or decision makers have quadratic utility functions. Unfortunately, the assumptions of the mean-variance model are subject to serious criticism in the empirical studies. If the distributions of hedged returns are asymmetric or the utility function of the decision maker is unknown, the traditional mean-variance criteria to evaluate effectiveness will not be suffice. In this article, we propose that, in addition to the first three moments of return distributions, the stochastic dominance rules and the extended mean-Gini coefficient be employed to analyze the performance of alternative futures and options hedging strategies.