IMA Journal of Management Mathematics (2010) 21, 1926

doi:10.1093/imaman/dpp013
Advance Access publication on June 25, 2009
Hedging mean-reverting commodities
UDO BROLL
Department of Business Management and Economics, Dresden University of Technology,
01062 Dresden, Germany
EPHRAIM CLARK
Middlesex University, The Burroughs, London NW4 4BT, UK, and Univ. Lille Nord de
France, Lille School of Finance, Euralille 59777, France
AND
ELMAR LUKAS
Department of Economics, University of Paderborn, 33098 Paderborn, Germany
[Received on 2 July 2008; accepted on 22 May 2009]
This paper uses the expected utility framework to examine the optimal hedging decision for commodities
with mean-reverting price processes. The derived results show that when commodity prices follow a
mean-reverting process, the optimal hedge ratio differs signicantly from the classical results found under
standard geometric Brownian motion. Hence, a failure to accommodate mean reversion when it exists can
lead to systematic biases in hedging decisions.
Keywords: commodity price risk; hedging; mean reverting.
1. Introduction
Corporate use of derivatives to hedge price exposure has become standard practice for rms, which
are increasingly willing to suffer substantial costs in nancial, physical and human resources to con-
ceive and implement their hedging strategies. This is well documented in the corporate hedging lit-
erature. For US rms, there are studies such as Gczy et al. (1997), Goldberg et al. (1998), Howton
& Perfect (1998), Graham & Rogers (2002), Allayannis & Ofek (2001) and Bartram et al. (2009).
Studies of non-US rms include Berkman & Bradbury (1996) on New Zealand rms, Hagelin (2003)
on Swedish rms, Pramborg (2005) on Swedish and Korean rms, Nguyen & Faff (2003) on Aus-
tralian rms, Bartram et al. (2009) on rms of 48 different countries and Heaney & Winata (2005)
on Australian rms. The International Swaps and Derivatives Association 2003 derivative usage sur-
vey reports that today 92% of the worlds 500 largest companies representing a wide range of ge-
ographic regions and industry sectors use derivatives for risk management on a regular basis (see
http://www.isda.org/statistics/surveynewsrelease030903v2.html).
According to the positive theory of corporate hedging developed by Smith & Stulz (1985), these
costs can be justied only if imperfect capital markets create conditions where corporate hedging re-
duces exposure and adds value to the rm. Another requirement is that the hedging strategy itself must
be appropriate. The bulk of the literature dealing with forward pricing decisions and optimal hedge ratios

Email: udo.broll@tu-dresden.de
c The authors 2009. Published by Oxford University Press on behalf of the Institute of Mathematics and its Applications. All rights reserved.

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20 U. BROLL ET AL.
focuses on price evolutions expressed by standard geometric Brownian motion (GBM). For example,
Benninga et al. (1983) investigate the optimal hedge under the traditional mean variance paradigm,
while Briys & Schlesinger (1993), Broll et al. (2001) and Wong & Ma (2008) have applied the less
restrictive expected utility framework. The problem with GBM, which treats price changes as indepen-
dent, is that in many cases, price changes are not independent and prices tend to return to an average
level once the effects of the innovation have dissipated. Bessembinder et al. (1995) note that on average
44% of a typical spot oil price shock will revert in the following 8 months, while other empirical stud-
ies have conrmed mean-reverting patterns for commodities such as copper and gold (e.g., Pilipovic,
1997; Pindyck & Rubinfeld, 1991), interest rates (Cox et al., 1985) and temperature (Brody et al., 2002;
Alaton et al., 2002) and see Schwartz (1997) for a general overview. Hedge ratios derived with a mis-
specied price process are unlikely to be optimal. The purpose of the present paper is to ll this gap and
examine optimal hedging behaviour for mean-reverting price processes.
Indeed, the mixed evidence with respect to corporate hedging and value creation suggests that hedg-
ing strategies might be far from optimal. For example, in a study of 119 US oil and gas producers,
Jin & Jorion (2006) nd no evidence that hedging has any signicant positive effect on rm value,
while Carter et al. (2006) in their study of 28 US airlines nd that rm value is positively related to
hedging of future jet fuel requirements. Bartram et al. (2009) nd a signicant positive value effect for
all derivatives users taken together but perversely only for rms without any nancial price exposure.
Allayannis & Weston (2001), Allayannis et al. (2001), Nain (2004) and Kim et al. (2006) nd evidence
that foreign currency derivatives hedging does add to rm value. However, Allayannis et al. (2007) nd
that the foreign currency hedging premium is statistically signicant and economically large only for
rms that have strong internal and external corporate governance. Guay & Kothari (2003) show that
the majority of rms using derivatives would not gain economically signicant cash ow benets in the
event of extreme movements in underlying market prices and conclude that derivative positions held by
non-nancial rms are small in economic magnitude. However, commodity price risk is not the only
source of concern for investors and rms. If the investment has an international dimension, exchange
rate risk and political risk are also important issues of economic exposure management, see, e.g., Kogut
& Kulatilaka (1994) and Clark (1997).
This paper follows the expected utility framework of Briys et al. (1990), Briys & Solnik (1992)
and Briys & Schlesinger (1993) to derive the optimal hedge ratio for a mean-reverting price process.
It then compares this ratio with the ratio for a price that follows GBM. The remainder of this article
is organized as follows. In Section 2, we present a continuous time stochastic model of an investor
specialized to commodity risk transactions. The investor can sell or buy protection contracts correlated
with the risk of the commodity. Section 3 examines and compares the derived optimal hedging positions.
Finally, Section 4 summarizes and concludes.
2. The model
In a continuous time stochastic framework, we examine how commodity derivatives are used in the
dynamic hedging decision making of a single investor. At any instant in time, the spot price s(t ) is
known. The stochastic element is the evolution of s(t ) over time, so that the wealth accumulation of the
investor over time is uncertain.
The spot rate s(t ) follows a square root mean-reverting process with a drift rate
s
(
s
s) R and
a variance parameter
s

s R
+
, which is a measure of the diffusion. We write this process as follows:
ds =
s
(
s
s)dt +
s

sdz
s
, (1)

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MEAN-REVERTING COMMODITIES 21
where dz
s
is the increment of a standard Wiener process. As opposed to standard GBM where prices
show an increasing unidirectional trend, this process exhibits a tendency to return to its mean value
s
over time (see Bj ork (2004), Andersson (2007)). This process is similar to the mean-reverting process
introduced by Vasicek (1977). However, it corrects the shortcoming of the Vasicek model such that the
spot prices cannot become negative. To assure this,
s

s
has to be greater than
2
/2. A process that
obeys this feature, i.e., a square root mean-reverting process, was rst introduced by Cox et al. (1985)
to model interest rate term structures.
In particular, if s(t ) is far greater than
s
at some point in time then we expect the drift of the
stochastic differential equation (SDE) to be negative, i.e., the probability that ds < 0 increases. On
the other hand, if s(t ) is far below
s
at some point in time then the drift of the SDE will be positive,
i.e., the probability that ds > 0 increases. The speed by which the process converges against its mean
over time is characterized by
s
. The mean-reverting pattern can be explained by means of noise trading.
Here, noise traders push prices away from fundamental values and rational traders respond to this by
forcing prices back to true equilibrium values.
The investor can use the derivative f to hedge the commodity risk. We assume that the time to
maturity of the futures contract perfectly matches the investors hedging horizon. The price dynamics
for ds and d f are not perfectly correlated, i.e., dz
f
dz
s
=
f,s
dt , where
f,s
measures the degree of
correlation between s and f . The futures price obeys a square root mean-reverting process too. Thus,
the futures price is characterized by:
d f =
f
(
f
f )dt +
f
_
f dz
f
, (2)
with drift
f
(
f
f ) R, diffusion parameter
f

f R
+
and Wiener increment dz
f
.
Now we turn to the wealth accumulation of an investor who cares about consumption C and his
utility maximization problem. The consumption expenditure of the investor over time is denoted by
Cdt . Consider a xed planning horizon T and total asset portfolio . Since portfolio revenues over time
are uncertain due to the stochastic evolution of the spot price, the investor is hedging against this risk
by taking a position in the derivative market for commodity risk. The purpose of hedging is to stabilize
the consumption path of the owner of the investment through a reduction in the variability of the wealth
accumulation path. The investor takes a hedge position with contract volume H.
Hence, the wealth accumulation equation is given by:
d = ds/s Cdt Hd f. (3)
Dening the hedge ratio with respect to portfolio as h = H f / and substituting the stochastic process
for the price dynamics gives the wealth accumulation equation
d =

)dt +

d, (4)
with

=
_
f
2
s
2h

f s
f

s

s, f
+h
2
s
2
f
s f
, (5)
and
d =

s

f dz
s
h
f

sdz
f

, (6)

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22 U. BROLL ET AL.
where

=
_
_

s
s
1
_

s
h
_

f
f
1
_

f
_
and

=
C

. The term d with E(d) = 0, E(d)

2
= dt ,
represents the stochastic term of wealth accumulation.
The investor cares about consumption C, where u(C) is a von NeumannMorgenstern utility func-
tion that exhibits risk aversion, i.e., u

(C) > 0, u

(C) < 0. The investors objective is to select con-

sumption, together with the given asset portfolio, in order to maximize the expected value of discounted
utility. The subjective discount rate is denoted by . Thus, the standard optimization problem under
uncertainty can be represented by:
V = max
C, h
E
_
T
0
u(C)e

d, (7)
subject to the stochastic wealth accumulation constraint.
Now we turn to the optimal consumption and hedging rules of the rm.
3. Hedging of mean-reverting commodities
Solving the maximization problem of the investor subject to the wealth constraint leads to the following:
PROPOSITION 3.1 Given a continuous time dynamic hedging framework with a stochastic mean-
reverting commodity, the optimal consumption rule and hedge ratio are described by:
u

(C

) = V

(, s, f, t ), (8)
h

=

s

s

s, f
+
(
f
f )
f

2
f
V

+
f
V

V
f
+

s

s

s, f
s
V

V
s
, (9)
Proof. The value function V(, s, f, t ) is dened as follows:
V(, s, f, t ) = max
C,h
E
_
T
0
u(C)e

d (10)
subject to the dynamic wealth accumulation equation and some initial and terminal conditions. Applying
Bellmans principle of optimality gives the HamiltonBellmanJacobi differential equation that results
to (Dixit & Pindyck, 1994):
V
t
= max
C,h
_
u(C) V

)V

(11)
+
s
(
s
s)V
s
+
f
(
f
f )V
f
+
1
2

2
_

2
s
s
+
h
2

2
f
f

2h
f

f s

fs
_
V

+
1
2

2
s
sV
ss
+
1
2

2
f
f V
ff
+
f
_
f
_

s
s

f s

h

f

f
_
V
f
+
s

s
_

s

s

h

f

f

fs
_
V
s
+
s

f
_
f s
fs
V
sf
_
,

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MEAN-REVERTING COMMODITIES 23
Maximization of the right-hand side of the equation leads to the optimality conditions:
0 =u

(C) V

(12)
0 =

f
(
f
f )
f
V

2
f
h
f

2
V

f

f s

s f

2
V

(13)

2
f
V
f

f

fs
_
s/f V
s
,
To gain additional insights and closed-form solutions to the optimal consumption and hedging rules,
special preferences of the hedger can be analysed. Examples for suitable utility functions are provided
by Briys et al. (1990), Adam-M uller (2000) and Wong & Ma (2008).
3.1 Optimal consumption rule
Proposition 1 determines the optimal consumption decision of the investor. It is the Euler equation for
optimal intertemporal consumption: the marginal utility of consumption u

(C) has to be equal to the

marginal utility of wealth V

(), where V(, s, f, t ) can be identied as the indirect utility function

of the investor. Intuitively, the Euler equation describes how consumption must behave over time. If
consumption does not evolve according to this rule, the investor can rearrange his consumption in a way
that raises utility without changing the present value of his spending.
3.2 Optimal risk policy
Proposition 1 also states the optimal hedge ratio. The rst term of the optimal hedge ratio captures the
pure hedging motive. This term describes the desire of the decision maker to stabilize intertemporal con-
sumption by incurring short or long positions in the derivatives market. The pure hedge term is a short
(long) hedge if the covariance between the future price and the spot rate is positive (negative). This
means an appropriate hedging volume intertemporally balances the cash ows and therefore, consump-
tion stabilization is possible. We see that the optimal hedge ratio with respect to this motive depends on
risk and correlation.
The second term is the speculative component of the optimal hedge policy. The futures market
may turn out to be in a situation of backwardation, which means that there is a risk premium on the
derivative. A risk-averse investor will take this into account and deviate from the variance minimiz-
ing hedge ratio. As can be seen, the degree of the speculative component depends on the investors
degree of relative risk aversion, which is measured by the expression V

/V

, and the variance of

the evolution of the futures price,
2
f
. The greater the risk aversion or the greater the variance of the
evolution of the futures price, the smaller becomes the speculative component, i.e., a hedge ratio close
to a pure hedge. The third and fourth terms of the optimal hedge rate are closely related. We will re-
fer to these terms as relative risk tolerance coefcients vis--vis the relevant state variable, i.e., the spot
rate and the derivative forward. We adopt this notation from Briys & Solnik (1992). As the formal
expression of the optimal hedge rates h

indicates, a rational expected utility maximizer will deviate

from the minimum variance hedge due to the existing cross-correlations affecting the state variables at
hand. Consequently, the size of this additional adjustment is determined by the investors degree of risk
aversion.
Now the main difference to a geometric Brownian modelling framework becomes obvious (see
Briys et al., 1990, for comparison). In such a setting, the optimal hedge ratio would have resulted
in h

=

s

f

s, f
+
f
/R, where
f
would be the drift term of the corresponding future price and

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24 U. BROLL ET AL.
R (
2
f
V

/V

) denotes the relative degree of risk aversion of the investor. What stands out rst
is that the result of (9) is now dependent on the spot and futures prices. Since both spot and futures
price are non-negative, the size of the hedge ratio increases (decreases) with the absolute size of f (s)
increasing. Furthermore, because f (t ) and s(t ) are implicitly dependent on time, the investor has to
deviate from a static hedge strategy. Instead he has to follow a dynamic hedging strategy where the
hedging position has to be adjusted at every instant of time. Moreover, the hedge ratio is inuenced
not only by the individual degree of risk aversion R but also by two relative risk tolerance coefcients,
i.e., V

/V
f
and V

/V
s
. Here, the overall impact of the third and fourth term in (9) will
depend on the sign of each of the relative risk tolerance coefcients. Given this context, stating a specic
utility function would make it possible to reveal further information with respect to the overall impact.
We leave this to future research.
Given an unbiased derviative market, i.e., future prices f reect the future value of current spot
prices s with perfect correlation in price dynamics, i.e., the prices obey the same Wiener process
(
f
dz
f

s
dz
s
) leads to the following corollary. An unbiased derivative market is dened as f
t
=
exp[r(T t )]s
t
.
COROLLARY When spot and futures prices are perfectly correlated and the derivative market is unbi-
ased, the optimal hedge ratio is given by
h

s
+
(
f
f )
f

2
f
V

+
f
V

V
f
+

s
s
V

V
s
. (14)
Hence, another interesting result stands out if we contrast (14) with the result provided by a classical
GBMsetting under the assumption of perfect correlation, i.e., h

= 1+
f
/R. For the sake of simplicity,
assume that the investor is to a very large extent risk averse. Then, instead of performing a full hedge, i.e.,
h

= 1, which motivates the investor to choose the amount of futures contracts according to H

= ,
the optimal hedge ratio for hedging mean-reverting commodities is signicantly different from1. Putting
it differently, performing a full hedge is almost impossible due to the fact that the pure hedge ratio is
dynamic in nature, i.e., proportional to h

f /s.
4. Conclusions
The paper presents a model of dynamic hedging where the underlying source of the risky wealth is an
unanticipated change in the commodity price risk. A position in the derivative market is used to hedge
the uncertain revenues. The purpose of hedging is to stabilize the consumption path of the investor
through a reduction in the variability of the wealth accumulation path. The magnitude and the direction
of hedging are determined by the degree of risk aversion, risk premium, distributions and market con-
ditions for derivatives. The derived results show that when commodity prices follow a mean-reverting
process, the optimal hedge ratio differs signicantly from the classical results derived under standard
GBM. Hence, a failure to accommodate mean reversion when it exists can lead to systematic biases in
hedging and investment decisions.
Acknowledgements
We would like to thank our anonymous referee and Phil Scarf (the editor) for their helpful and construc-
tive comments and suggestions.

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MEAN-REVERTING COMMODITIES 25
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