MINIMUM-VARIANCE

FUTURES HEDGING
UNDER ALTERNATIVE
RETURN SPECIFICATIONS
ERIC TERRY

It is widely believed that the conventional futures hedge ratio, ssf兾s2f , is

variance-minimizing when it is computed using percentage returns or log
returns. It is shown that the conventional hedge ratio is variance-minimizing
when computed from returns measured in dollar terms but not from
returns measured in percentage or log terms. Formulas for the minimum-
variance hedge ratio under percentage and log returns are derived. The
difference between the conventional hedge ratio computed from percent-
age and log returns and the minimum-variance hedge ratio is found to be
relatively small when directly hedging, especially when using near-maturity
futures. However, the minimum-variance hedge ratio can vary significantly
from the conventional hedge ratio computed from percentage or log
returns when used in cross-hedging situations. Simulation analysis shows
that the incorrect application of the conventional hedge ratio in cross-
hedging situations can substantially reduce hedging performance. © 2005
Wiley Periodicals, Inc. Jrl Fut Mark 25:537–552, 2005

Some of the research for this paper was completed while the author was a Visiting Scholar at the
Center for Financial Engineering, National University of Singapore. A research grant from the School
of Business at Central Connecticut State University and the helpful comments by an anonymous
referee are acknowledged.
For correspondence, Department of Finance, Vance Academic Center #427, 1615 Stanley Street,
Central Connecticut State University, New Britain, Connecticut 06050; e-mail: terrye@ccsu.edu
Received January 2004; Accepted September 2004

■ Eric Terry is an Associate Professor of Finance in the School of Business at Central

Connecticut State University in New Britain, Connecticut.

The Journal of Futures Markets, Vol. 25, No. 6, 537–552 (2005) © 2005 Wiley Periodicals, Inc.
Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/fut.20153
538 Terry

INTRODUCTION
It is widely known that the variance-minimizing futures hedge is given by
the ratio of the conditional covariance of the futures and spot returns
to the conditional variance of the futures return. This standard result can
be found in virtually every leading derivatives or risk management textbook
(Hull, 2002; Kolb, 2003). There is, however, much confusion over the
conditions under which this result holds. This result has been asserted—
either explicitly or implicitly—when returns are measured in dollar
terms (Anderson & Danthine, 1981; Ederington, 1979; Johnson, 1960),
percentage terms (Ceccetti, Cumby, & Figlewski, 1988; Lien, Tse, &
Tsui, 2002), and log terms (Baillie & Myers, 1991; Brooks, Henry, &
Persand, 2002; Gagnon & Lypny, 1995; Geppert, 1995; Harris & Shen,
2003; Kroner & Sultan, 1993; Park & Switzer, 1995; Poomimars, Cadle, &
Theobald, 2003).
This problem has its roots in the earliest papers on futures hedging.
In their pioneering work on futures hedging, neither Ederington (1979)
nor Johnson (1960) explicitly state the type of returns being used in
their derivation of the minimum-variance hedge ratio—although a care-
ful reading of both articles shows that they were using dollar returns.
The next generation of hedging papers repeat the derivations of
Ederington (1979) and Johnson (1960) while assuming that they are
valid for percentage or continuously compounded returns (Baillie &
Myers, 1991; Ceccetti, Cumby, & Figlewski, 1988; Geppert, 1995;
Gagnon & Lypny, 1995; Kroner & Sultan, 1993; Park and Switzer,
1995). More recent articles merely cite one or more of these earlier
papers and then proceed to apply the conventional hedge ratio to
either percentage or continously compounded returns (Brooks,
Henry, & Persand, 2002; Harris & Shen, 2003; Lien, Tse, & Tsui, 2002;
Poomimars, Cadle, & Theobald, 2003).
In this article, we examine the minimum-variance hedge ratio
(MVHR) under alternative return specifications. Formulas for the
MVHR are derived for cases in which returns are measured in dollar
terms, percentage terms, and log terms. These formulas are shown not to
be sensitive to alternative definitions of variance minimization. It is
found that the conventional hedge ratio—given by the ratio of the condi-
tional covariance of the futures and spot returns to the conditional vari-
ance of the futures return—is variance-minimizing when computed from
returns measured in dollar terms but not from returns measured in per-
centage or log terms. The conventional hedge ratio computed from
 Minimum-Variance Futures Hedging 539

percentage returns, however, does give the dollar amount of futures in

the minimum-variance hedge per dollar of spot position.
The difference between the conventional hedge ratio computed from
percentage and log returns and the MVHR is found to be relatively small
when directly hedging, especially when using near-maturity futures.
Because all of the articles cited above have examined this specific case in
their empirical work, it is not surprising that the conventional hedge has
appeared to perform well when calculated from percentage or continously
compounded returns. However, the MVHR can vary significantly from the
conventional hedge ratio computed from percentage or log returns when
used in cross-hedging situations. Simulation analysis shows that the
incorrect application of the conventional hedge ratio can substantially
reduce hedging performance in cross-hedging situations.

HEDGING TO MINIMIZE PAYOFF VARIANCE

Consider a firm that is long one unit of a particular asset at time t
1. A
decision is made to hedge this position until time t using a specified
futures contract. Let ht
1 represent the short position taken in the futures
market at time t
1 under the adopted hedging strategy. Ignoring daily
resettlement, the net payoff to the hedging firm will be

Pt  St
ht
1[Ft
Ft
1] (1)

where St and Ft are the respective spot and futures prices at time t. It is
assumed that the firm’s objective is to minimize the variance of this net
payoff. This objective is equivalent to mean-variance utility maximization
when the expectations hypothesis holds, i.e., the futures price equals the
expected future spot price. Under the additional condition that spot and
futures price changes follow a symmetric distribution, this objective is
also equivalent to minimizing value-at-risk.

Using Dollar Returns

Suppose the hedger prefers to compute the MVHR using dollar returns.
Let Rdst ⬅ St
St
1 and Rdft ⬅ Ft
Ft
1 represent the spot and futures
returns in dollar terms for period t. Using these definitions, the net
payoff to the hedging firm can be expressed as

Pt  St
1  Rdst
ht
1Rdst

540 Terry

The conditional variance at time t
1 of this payoff is

Vart
1 (Pt )  Vart
1 (Rdst )
2ht
1Covt
1 (Rdst, Rdft )  h2t
1Vart
1 (Rdft )

Taking the first-order necessary condition for a minimum and solving,
we find that the minimum-variance hedge ratio for dollar returns is
given by
Covt
1 (Rdst, Rdft )
h*t
1  (2)
Vart
1 (Rdft )

Thus, when spot and futures returns are expressed in dollar terms,
the MVHR is given by the ratio of the conditional covariance of the
futures and spot returns to the conditional variance of the futures return.
In other words, the conventional hedge ratio is variance-minimizing when
returns are measured in dollar terms. This merely restates the standard
hedging result first shown by Johnson (1960) and Ederington (1979).

Using Percentage Returns

Now suppose the hedger prefers to compute the MVHR using percent-
age returns. Let Rpst ⬅ (St
St
1 )兾St
1 and Rpft ⬅ (Ft
Ft
1 )兾Ft
1 repre-
sent the spot and futures returns in percentage terms for period t. It
should be noted that, because no investment is needed for the futures
position beyond the required margin, Rpft technically represents the per-
centage change in the futures price rather than the percentage return on
each futures contact. However, we follow the usual convention of refer-
ring to this term as the percentage futures return for ease of exposition.
This convention will also be followed when log returns are considered.
If we substitute for the end-of-period spot and future prices using
the two return definitions above, net payoff (1) can be rewritten as

Pt  St
1 (1  Rpst )
ht
1Ft
1Rpft

At time t
1, the conditional variance of this payoff is

Vart
1 (Pt )  S2t
1Vart
1 (Rpst )
2ht
1St
1Ft
1Covt
1 (Rpst, Rpft )

 h2t
1F2t
1Vart
1 (Rpft )
By taking the first-order necessary condition and solving, the MVHR for
percentage returns is found to be
p p
St
1 Covt
1 (Rst, Rft )
h*t
1   (3)
Ft
1 Vart
1 (Rpft )
 Minimum-Variance Futures Hedging 541

This differs from the conventional hedge ratio due to the inclusion of a
term reflecting the initial spot price relative to the initial futures price.
Failure to account for this term will lead to computed hedge ratios that
tend to underestimate the MVHR when the spot price is above the
futures price and overestimate it when the spot price is below the futures
price. The greater is the difference between the spot and futures prices,
the greater will be the error produced by applying the conventional
hedge ratio to percentage returns. Only when the spot and futures prices
are identical will the conventional hedge ratio be variance minimizing for
percentage returns.
Before proceeding to the final case, it should be noted that
Equation (3) implies that

Ft
1 Covt
1 (Rpst, Rpft )

t
1 ⬅
H*  h*
t
1  (4)
St
1 Vart
1 (Rpft )

where H* t
1 represents the dollar amount of futures in the optimal hedge
per dollar of spot position held. This demonstrates that the conventional
hedge ratio does have a valid interpretation when computed from per-
centage returns. It describes the dollar amount of futures in the
minimum-variance hedge per dollar of spot position rather than the num-
ber of futures contracts per unit of asset being hedged. Under this
definition of the optimal hedge, the firm is completely hedged when
H*t
1  Ft
1兾St
1 rather than one. Neither Ceccetti, Cumby, and Figlewski
(1988) nor Lien, Tse, and Tsui (2002) use this representation of the
minimum-variance hedge when applying the conventional hedge ratio to
percentage returns.

Using Continuously Compounded Returns

Finally, suppose the hedger prefers to compute the MVHR using contin-
uously compounded returns. Let Rcst ⬅ ln(St兾St
1 ) and Rcft ⬅ ln(Ft兾Ft
1 )
represent the spot and futures returns in log terms for period t. Substitu-
ting these definitions into Equation (1), the hedger’s net payoff can be
expressed as

Pt  St
1 exp5Rcst 6
ht
1Ft
1[exp5Rcft 6
1]

Unlike the previous two cases, an assumption about the conditional dis-
tribution of the spot and futures returns is required in order to derive the
MVHR. Following standard practice, we assume that they follow a
542 Terry

bivariate normal distribution. Assuming bivariate normality, the condi-

tional variance at t
1 of the above payoff is

Vart
1 (Pt )  S2t
1 exp 52Et
1 (Rcst )6 exp 5Vart
1 (Rcst )6 [exp5Vart
1 (Rcst )6
1]

2ht
1St
1Ft
1 exp5Et
1 (Rcst )6 exp5Et
1 (Rcft )6 exp5Vart
1 (Rcst )兾26
 exp5Vart
1 (Rcft )兾26 [exp5Covt
1 (Rcst, Rcft )6
1]
 h2t
1F2t
1 exp52Et
1 (Rcft )6 exp5Vart
1 (Rcft )6 [exp5Vart
1 (Rcft )6
1]

Taking the first-order necessary condition and solving, the MVHR for
continuously compounded returns is given by

St
1 exp5Et
1(Rcst )6 exp5Vart
1 (Rcst )兾26 exp5Covt
1 (Rst, Rft )6
1

c c

t
1 
h*   
Ft
1 exp5Et
1 (Rcft )6 exp5Vart
1 (Rcft )兾26 exp5Vart
1 (Rcft )6
1
(5)

This formula significantly differs from the conventional hedge ratio.

The optimal hedge ratio for this case consists of four multiplicative
terms. The first term is the ratio of the initial spot price to the initial
futures price. The second and third terms capture the relative amount
of drift and volatility that is expected in spot and futures prices over
the hedging period. The final term, similar to the conventional hedge
ratio, measures the conditional covariance of the futures and spot
returns relative to the conditional variance of the futures return. Note
that hedging formula (5) involves the expected spot and futures
returns as well as the conditional variance of the spot return. In con-
trast, the conventional hedge ratio does not depend on any of these
three values.
As noted earlier, the MVHR for continuously compounded returns
depends upon the assumed distribution of the conditional spot and
futures returns. The presence of either skewness or kurtosis in the con-
ditional log returns would cause the minimum-variance hedge to differ
slightly from that given in Equation (5). However, we are not aware of
any return distribution under which the MVHR would correspond to the
conventional hedge ratio.

Discussion
Before examining the robustness of these results, several comments
should be made. First, MVHR Equations (2), (3), and (5) should not be
viewed as separate formulas but instead as the same underlying formula
 Minimum-Variance Futures Hedging 543

expressed in three different forms. If we take hedge ratio (2) and make
the change of variables Rpst  Rdst兾St
1 and Rpft  Rdft兾Ft
1, we find that

Covt
1 (Rdst, Rdft )

h*t
1 
Vart
1 (Rdft )
Covt
1 (St
1Rpst, Ft
1 Rpft )

Vart
1(F2t
1 Rpft )
p p
St
1 Covt
1 (Rst, Rft )
 
Ft
1 Vart
1 (Rpft )

which is hedge ratio (3). This demonstrates that hedge ratios (2) and
(3) are equivalent. Similarly, the identities Rcst  ln(1  Rdst兾St
1 ) and
Rcft  ln(1  Rdft兾St
1 ) can be used to show that hedge ratios (2) and (5)
are equivalent. Thus, MVHR formulas (3) and (5) are merely transformed
versions of conventional hedge ratio (2).
Second, these results should not be interpreted as implying that it is
better to compute the MVHR using dollar returns rather than percentage
returns or log returns. The choice of which type of returns to use when esti-
mating hedge ratios depends on the perceived statistical properties of these
returns. Most practitioners prefer to work with percentage returns or log
returns rather than dollar returns because expected returns and return
volatility are generally considered to be proportional to price levels. An addi-
tional reason for using continuously compounded returns is that the cost-
of-carry formula is linear in log prices: ln(Ft)  ln(St)  c(T
t), where c is
the net cost-of-carry and T is the futures maturity date. Our results merely
state that the correct formulas to use when computing the MVHR from
percentage or log returns are Equations (3) and (5), respectively, rather
than the conventional hedge ratio. The conventional hedge ratio corre-
sponds to the MVHR only when it is computed using dollar returns.
Finally, it should be noted that our results are not dependent on any
specific form for the joint spot and futures return process. No assump-
tions were made about this process except that it has well-defined condi-
tional first and second moments. The conditional means of the return
process could include autoregressive terms (Howard & D’Antonio, 1991),
cointegration (Kroner & Sultan, 1993) or fractional cointegration (Lien &
Tse, 1999) terms, time to maturity effects (Low, Muthuswamy, Sakar, &
Terry, 2002), terms reflecting external information (McNew & Fackler,
1994), or even dependences on other futures prices (Neuberger, 1999).
Meanwhile, the conditional second moments could include GARCH
544 Terry

(Baillie & Myers, 1991) or stochastic volatility (Lien & Wilson, 2001)
effects, terms reflecting external information (McNew & Fackler, 1994),
or time to maturity effects (Low, Muthuswamy, Sakar, & Terry, 2002).
Thus, our results are applicable to all minimum-variance futures hedging
models.

HEDGING TO MINIMIZE RETURN VARIANCE

In the previous section, the MVHR when the hedging firm seeks to mini-
mize the variance of its net payoff was analyzed. To examine the robustness
of these results, the MVHR when the hedger instead seeks to minimize
return variance is next examined.

Minimizing Dollar Return Variance

Assume first that the objective of the hedging firm is to minimize the
variance of its dollar return between times t
1 and t. Ignoring daily
resettlement, the dollar return to the hedging firm is given by

Rdt  Rdst
ht
1Rdst

Substituting Rdst  St
St
1 and Rdft  Ft
Ft
1 into this equation, the
hedger’s dollar return can be rewritten as

Rdt  [St
St
1]
ht
1[Ft
Ft
1]

Comparing this with Equation (1), it is found that

Rdt  Pt
St
1

i.e., the firm’s dollar return is equal to the firm’s net payoff less the initial
spot price. Because the initial spot price is deterministic at time t
1,
this relationship implies that

Vart
1 (Rdt )  Vart
1 (Pt )

Consequently, the objective of minimizing the conditional variance of the

firm’s dollar return is equivalent to minimizing the conditional variance of
the firm’s net payoff. It immediately follows from our previous results that
the MVHR is given by Equation (2) when it is computed using dollar
returns, Equation (3) when it is computed using percentage returns, and
Equation (5) when it is computed using continuously compounded returns.
Thus, under this alternative hedging objective the conventional hedge ratio
continues to be variance-minimizing when returns are measured in dollar
terms but not when they are measured in percentage or log terms.
 Minimum-Variance Futures Hedging 545

Minimizing Percentage Return Variance

Assume now that the objective of the hedging firm is to minimize the
variance of its percentage return between times t
1 and t. The per-
centage return to the firm, Rt, is given by
[St
St
1]
ht
1[Ft
Ft
1]
Rpt 
St
1
Pt

1 (6)
St
1

where Pt, the net payoff from the hedger’s spot and futures position, is
given by Equation (1). Because the initial spot price is deterministic at
time t
1, this equation implies that the return variance is related to the
variance of the firm’s net payoff by
Vart
1 (Pt )
Vart
1 (Rpt ) 
S2t
1
As in the previous case, minimizing the conditional variance of the firm’s
percentage return is equivalent to minimizing the conditional variance of
the firm’s net payoff. Therefore, the MVHR under this alternative objec-
tive continues to be given by Equation (2) when computed using dollar
returns, Equation (3) when computed using percentage returns, and
Equation (5) when computed using continuously compounded returns.
Thus, the conventional hedge ratio is once again variance-minimizing
when returns are measured in dollar terms but not when they are meas-
ured in percentage or log terms.
Note that the firm’s percentage return (6) can be rewritten as

Rpt  Rpst
Ht
1Rpft

where Rpst ⬅ (St
St
1 )兾St
1 and Rpft ⬅ (Ft
Ft
1 )兾Ft
1 represent the
percentage spot and futures returns, and Ht
1  ht
1Ft
1兾St
1 represents
the dollar amount of futures in the hedge per dollar of spot position held.
Taking the first-order necessary condition for a minimum and solving,
the minimum-variance hedge ratio is given by
Covt
1 (Rpst, Rpft )
t
1 
H*
Vart
1 (Rpft )
This is merely reiterates our previously shown result that the conventional
hedge ratio describes the dollar amount of futures in the minimum-
variance hedge per dollar of spot position rather than the number of
futures contracts per unit of asset being hedged when returns are meas-
ured in percentage terms.
546 Terry

Minimizing Log Return Variance

Finally, assume that the firm’s objective is to minimize the variance of its
continuously compounded return over the hedging period. Ignoring daily
resettlement, the hedger’s log return will be
Rct  ln(St
ht
1[Ft
Ft
1])
ln(St
1 )

Because continuously compounded returns are not cross-sectionally

separable, i.e., ln(1  RA  RB )  ln(1  RA)  ln(1  RB), this return
cannot divided into separate spot and futures returns. As a result, a
closed-form solution for the minimum-variance hedge ratio does not
exist. However, the minimum-variance hedge ratio can be approximated
by applying a Taylor series expansion of the ln() function. The first-order
Taylor series approximation ln(1  R) ⬇ R implies that the hedger’s log
return can be approximated by its simple return:
[St
St
1]
ht
1[Ft
Ft
1]
Rct ⬇
St
1

Using the results from the previous subsection, it follows that the MVHR
is approximately equal to conventional hedge ratio (2) when computed
from dollar returns, Equation (3) when computed from percentage
returns, and Equation (5) when computed from continuously com-
pounded returns.
Better approximations of the MVHR can be obtained by including
higher-order terms in the Taylor series expansion. However, the resulting
formulas for the MVHR continue to differ from the conventional hedge
ratio when returns are measured in either percentage or log terms.
Furthermore, the complexity of the resulting formulas increase geomet-
rically as additional terms are included in the approximations. For these
two reasons, such higher-order approximations are not presented in this
article.

EMPIRICAL IMPLICATIONS
The previous sections have shown that the MVHR differs from the con-
ventional hedge ratio when returns are measured in either percentage or
log terms. Furthermore, this result is not sensitive to alternative defini-
tions of variance minimization. In this section, the economic signifi-
cance of these results are examined.
Convergence of the futures basis implies that Ft ⬇ St for direct
hedging using near-term contacts. Applying this approximation to
 Minimum-Variance Futures Hedging 547

Equation (3), it is found that

Covt
1 (Rpst, Rpft )
h*t
1 ⬇
Vart
1 (Rpft )

Thus, the conventional hedge ratio computed using percentage returns

will closely approximate the MVHR when the firm is directly hedging
using near-term futures contacts. Similar arguments show that the con-
ventional hedge ratio computed using log returns also will closely
approximate the MVHR for the case of direct hedging using near-term
futures contacts.
For direct hedging using longer-term futures contacts, spot and
futures prices can deviate from each other somewhat, but only within
the bounds set by physical (or financial) arbitrage. Consequently, the
conventional hedge ratio computed using either percentage or log
returns will differ from the MVHR by only a relatively small amount.
Consider the case of directly hedging a portfolio that tracks the Nikkei
index using the Nikkei futures contracts traded on the Singapore
General Exchange (formerly SIMEX). Figure 1 shows the ratio of spot to
futures price as a function of the futures time to maturity over the period
1987 through 1999 inclusive, excluding the week of and the week
following the October 1987 stock market crash. The observed range for
the ratio of spot to futures price increases as the futures maturity

FIGURE 1
Ratio of spot to futures price for the Nikkei Index by futures maturity.
548 Terry

lengthens, but only within narrow bounds. For maturities of between

20 and 25 weeks, this ratio never exceeds 1.02 or falls below 0.945.
From Equation (3), this implies that the conventional hedge ratio
computed using percentage returns would have overestimated the
MVHR by (1
.945)兾.945  5.8% at most and underestimated it by
(1.02
1)兾1.02  2.0% over this period using futures maturities of
between 20 and 25 weeks.
For cross hedging, however, the minimum-variance hedge ratio for
either percentage or log returns can differ significantly from the conven-
tional hedge ratio. Consider the case of hedging a spot position in Dubai
crude oil using the nearest light sweet oil futures contract traded on
NYMEX. Using mid-week (Wednesday) closing spot prices and futures
settlement prices over the period 1992 to 2002 inclusive, the average
ratio of spot to futures price was 0.861, with a maximum value of 0.966
and a minimum value of 0.688. From Equation (3), this implies that the
conventional hedge ratio computed using percentage returns would have
overestimated the MVHR by an average of (1
.861)兾.861  16.2% over
this 11-year period, with the actual amount of this overestimation varying
from 3.5% to 45.4%.
To determine whether such deviations from the MVHR significantly
impact hedging performance, a series of simulations were conducted.
For direct hedging, the constant-correlation GARCH model of Kroner
and Sultan (1993) was used:

Rst  ms  us[ln(St
1 )
ln(Ft
1 )]  Pst

Rft  mf  uf [ln(St
1 )
ln(Ft
1 )]  Pft

where the conditional variance–covariance matrix for the residual errors

is given by

h2st rhsthft
at  a b
rhsthft h2ft

and the conditional variance terms follow the GARCH(1,1) processes

h2st  cs  asP2st
1  bsh2st
1

h2ft  cs  asP2ft
1  bsh2ft
1

For cross hedging, the cointegration terms were removed from the above
model. The simulations were conducted using the parameters estimated
by Kroner and Sultan for the British Pound, Canadian Dollar, Japanese
Yen, and Swiss Franc. (The estimated GARCH parameters for the
 Minimum-Variance Futures Hedging 549

German Mark were mean-fleeting, which led to negative return volatili-

ties arising frequently in the scenarios, and so this currency was omitted
from the simulations.) No significant differences were noted in the
simulation results across the four currencies, which indicates that the
simulation results are not very sensitive to the assumed return parame-
ters. Consequently, simulation results were averaged across the four
currencies.
The simulation results, given in Table I, were based on 1,000 repli-
cations of a 250-week time series for each of the four currencies. For
direct hedging, the results were not sensitive to the initial ratio of spot
to futures price and so the results for S0兾F0  1 are presented. The
conventional hedge ratio deviated from the MVHR by an average of
0.60% when computed using percentage returns and by an average
of 0.52% when computed using log returns. Hedging performance, meas-
ured by the conditional variance of the hedger’s return, fell by somewhere
between 0.08% and 0.11% when the conventional hedge ratio was used

TABLE I
Simulated Performance of the Conventional Hedge Ratio
When Computed From Percentage and Log Returns

Cross hedging

Direct S0兾F0 S0兾F0 S0兾F0 S0兾F0 S0兾F0 S0兾F0

hedging  0.8  0.9  1.0  1.1  1.2  1.3

Hedge ratio computed from percentage returns

Average percentage deviation 0.07 24.17 5.42
0.76
9.70
17.29
23.65
from MVHR
Mean percentage standard 0.60 24.59 11.21 3.62 10.23 17.54 23.81
deviation from MVHR
Loss in hedging efficiencya
Dollar returns 0.11 59.24 25.21 4.38 22.26 43.22 57.36
Percentage returns 0.11 58.97 24.12 3.78 21.82 43.25 57.31
Log returns 0.10 58.98 24.17 3.81 21.98 43.43 57.51

Hedge ratio computed from log returns

Average percentage deviation 0.07 24.31 5.54
0.66
9.60
17.20
23.56
from MVHR
Mean percentage standard 0.52 24.72 11.35 3.60 10.14 17.46 23.73
deviation from MVHR
Loss in hedging efficiencya
Dollar returns 0.08 59.54 25.76 4.43 22.02 42.98 57.18
Percentage returns 0.08 59.23 24.59 3.80 21.61 43.03 57.16
Log returns 0.09 58.82 24.12 3.64 20.79 42.11 56.35

a
Given by the percentage reduction in the conditional variance of the hedger’s return under the MVHR versus the
conventional hedge ratio.
550 Terry

instead of the MVHR, depending on the type of returns used to measure

hedging performance and the type of returns used to compute the con-
ventional hedge ratio. Thus, the economic loss from using the conven-
tional hedge ratio computed from either percentage or log returns instead
of using the actual MVHR appears to be quite small.
The simulation results for cross hedging were highly dependent on
the initial ratio of spot to futures price. When this price ratio was set to
one, the reduction in hedging efficiency from using the conventional
hedge ratio computed from percentage or log returns instead of using
the MVHR was found to be between 3.6% and 4.4%, depending on the
type of returns used to measure hedging performance. As the initial spot
to futures price deviated from one, the performance of the conventional
hedge ratio deteriorated rapidly. When the initial ratio of spot to futures
price was 1.1, the conventional hedge ratio computed from percentage
or log returns performed over 20% worse than the MVHR. The conven-
tional hedge ratio computed using percentage or log returns performed
over 42% worse than the MVHR when the initial spot to futures price
ratio was 1.2 and over 56% worse when the initial spot to futures price
ratio was 1.3. Similar results were found as the initial spot to futures
price ratio fell below one. These results indicate that the conventional
hedge performs substantially worse for cross hedging than for direct
hedging when it is computed from percentage or continuously com-
pounded returns. In addition, even relatively small deviations between
the spot and futures price can lead to a substantial reduction in hedging
efficiency when the conventional hedge ratio is incorrectly applied to
percentage and log returns.

CONCLUSIONS
In this article, we examined the minimum-variance hedge ratio when it
is computed from alternative return specifications. Formulas for the
minimum-variance hedge were derived for cases in which returns are
measured in dollar terms, percentage terms, and log terms. These formulas
were shown not to be sensitive to alternative definitions of variance mini-
mization. It was found that the conventional hedge ratio—given by the
ratio of the conditional covariance of the futures and spot returns to
the conditional variance of the futures return—is variance-minimizing
when returns are measured in dollar terms but not when they are meas-
ured in percentage or log terms.
The difference between the conventional hedge ratio computed
from percentage or log returns and the variance-minimizing hedge ratio
 Minimum-Variance Futures Hedging 551

was shown to be relatively small when directly hedging using near-

maturity futures. Because all of the articles cited herein have examined
this specific case in their empirical work, it is not surprising that the
conventional hedge has appeared to perform well when calculated using
percentage or log returns. In contrast, it was shown that the minimum-
variance hedge ratio can vary significantly from the conventional hedge
ratio computed from percentage or log returns in cross hedging situa-
tions. Simulation analysis indicates that the incorrect application of the
conventional hedge ratio can substantially reduce hedging performance
in such cross-hedging situations.

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