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Optimal Hedging in Futures Markets with Multiple Delivery Specifications

Avraham Kamara, Andrew F. Siegel

Abstract

ABSTRACT Nearly all futures contracts allow delivery of any of several qualities of the underlying asset. Consequently, the price of the futures contract is associated more with the price of the expected cheapest deliverable variety than with the price of the par‐delivery variety. The delivery specifications introduce a delivery risk for every hedger in the market. We derive the optimal hedging strategies in these markets. Their hedging effectiveness is evaluated for wheat futures contracts in Chicago. Hedging optimally would have significantly reduced the variance of the rates of return on hedges while yielding similar mean returns.

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Key concepts: Futures contract, Deliverable, Variety (cybernetics), Economics, Financial economics, Forward market, Asset (computer security), Variance (accounting)