A reformulation of the portfolio model of hedging

The portfolio approach to hedging assumes that the p ¡ motivation for hedging is risk reduction. The paper eexamines the portfolio approach to hedging and respecifies the model in such a way that hedge ratios are estimated using returns rather than price levels. Using the same data set, hedge ratios estimated using price levels differ from one while hedge ratios using returns are found to be insignificantly different from one. The results do not support he portfolio approach to hedging. Therefore, one must look elsewhere for empirical support for the risk-reduction theory of hedging. Key words: hedging, portfo l io model, risk reduct ion. Johnson and Stein (JS hereafter) in the early 1960s attempted to use the portfolio theory developed by Markowitz for securities to ra-tionalize the observation that participants in futures markets are often ot fully hedged. JS argued that a combination of spot and futures positions may be analyzed asa two-security portfolio and that it may be rational under some circumstances to be less than fully hedged. The JS approach tended to support the traditional theory of hedging which held that the primary motivation for hedging was risk reduction. The traditional theory was figorously challenged by Working (1953a,b, 1962), who argued that the major motivation for hedging was not o reduce risk but rather to profit from favorable changes in basis and/or to use futures markets as an aid in pricing cash commodities. 1 ~~he JS theoretical results have been rein-forced by empirical tests of the portfolio model in which it is found that hedge ratios estimated using simple regression techniques are often less than one. For instance, Ederington is able to make the statement: "Contrary to the traditional hedging theory 9.. our empirical results indicate that eve