Mean-Variance Versus Minimum-Variance Hedging

Abstract

The hedging model introduced in this chapter is an extension of the expected utility approach in Chap. 2 The importing firm’s hedging problem here is almost identical to the one before. The only difference is that this model allows for basis risk. This is important with regard to the definition of backwardation applied. While in the previous chapter backwardation is defined as the difference between the expected spot price and the current futures price (i.e., $\tilde{{e}}_{1} - {f}_{0}$), here, backwardation is defined as the difference between the expected futures price and the current futures price (i.e., $\tilde{{f}}_{1} - {f}_{0}$). Note that these two definitions of backwardation are equal in the absence of basis risk (i.e., if $\tilde{{e}}_{1} =\tilde{ {f}}_{1}$). However, aside from basis risk, the model framework is quite different, since the analysis in this chapter is based on the mean-variance concept. Nevertheless, this approach can be regarded as an extension, since mean-variance models are generally not in conflict with expected utility models.¹ On the contrary, mean-variance models have several attractive properties that may add additional insights.