Estimation of Time-Varying Hedge Ratios for Coffee

Abstract: This paper will gain better insights of how to calculate the hedge ratio to reduce the basis risk and protect against the price volatility, which is caused by the mismatch between the spot and future prices. This will be done by calculating the time-varying hedge ratio for the Colombian mild Arabica coffee, using two BGARCH models, the diagonal BEKK and diagonal VECH. Four different hedging strategies performance are compared with the minimum variance criterion, during the period of 10 years between January 2003 and March 2013. We can conclude that the time-varying hedge ratio has the smallest minimum variance out of the four portfolios. Further we can conclude that, the time-varying hedge ratio hasn’t a significant difference in the performance, compared to OLS static hedge ratio or the naïve hedge. Therefore the reduction of the basis risk is marginal.