An Evaluation of Alternative Optimal Hedging Derivations

Optimal hedging can be derived and estimated in compact and decomposed forms (Chen, 1988; Sarassoro, 1988). The objectives of this study are to evaluate their performance and to compare them with the routine hedge and cash purchases empirically. Optimal hedging models are derived for Taiwan's hedging of com import demand in the CBOT under the assumption that the importers' disutility is a function of expected cost and variation of costs. This study uses monthly data from January 1976 to September 1985 to simulate the monthly purchasing costs from January 1986 to December 1990 under alternative optimal hedging, routine hedge, and cash strategies. The expected terms in the optimal hedging formulae are forecasted by ARIMA models. The performance of the strategies are evaluated based on the mean-standard deviation criterion. The results indicate that during the sample period the use of the compact optimal hedging model is the best strategy among the strategies considered in this study. The reason for the domination of compact over the decomposed optimal hedging is that less variables are to be forecasted in the former case. While the domination of cash purchases to the routine hedge come solely from the downtrending futures prices during the sample period except when there were serious droughts. Therefore if the mean and variation of the costs are of the major concern, the Taiwan importers of com should be aware of and follow the models and conclusions as suggested in this study.