An Integrated-Signal Approach to Selective Hedging

Producers and consumers of commodities are likely to trade commodity futures with the dual intention of mitigating spot price risk and extracting profits through speculation, a practice known as selectively hedging. We put forward an integrated-signal approach to selective hedging that formalizes the speculative component as a function of multiple commodity return predictors, the economic agent’s degree of risk aversion and the uncertainty of the spot market. The implementation for a cross-section of 19 commodities shows that selective hedging significantly reduces spot price risk, like pure hedging, while it generates profitability in the form of a Sharpe ratio improvement of 58% on average. The latter is partly compensation to the selective hedger for the drawdowns incurred through speculation when funding liquidity plunges and when economic activity slows down. The findings are not challenged by sub-period analyses, reformulations of the pure and speculative components, nor transaction costs