Robustness results for regression hedge ratios: Futures contracts with multiple deliverable grades

The suitability of the regression technique in determining hedge ratios in the case of futures contracts with multiple deliverable grades is reexamined from a practitioner's point of view. The Chicago Board of Trade (CBOT) wheat futures contract is chosen which has 2 principal deliverable grades, and for which a hedge ratio formula has recently been proposed by Kamara and Siegel, assuming that hedges are lifted at maturity. Although the formula derived by Kamara and Siegel is theoretically superior under the maintained assumptions, it is shown that, in practice, the traditional time-series regression hedge ratio does very well if spot-futures price convergence at maturity is uncertain. A modified regression hedge ratio, which is constructed from a cross-section of contracts, is introduced. The cross-contract hedge ratio does as well as Kamara-Siegel solution if spot-futures convergence at maturity is not guaranteed, and does substantially better if spot-futures convergence is guaranteed.