Futures Hedge Profit Measurement, Error-Correction Model vs. Regression Approach Hedge Ratios, and Data Error Effects

This paper proposes that, and explains why, hedge profits and regression approach hedge ratios should be calculated using cost-of-carry-adjusted price changes. This Modified Regression Method for determining hedge ratios is denoted MRM. The paper discusses the Error-Correction Model for hedge ratio determination as it has been applied (denoted ECM), discuss how it should be applied, and relates each to the MRM. Data errors can cause the MRM hedge ratios to be smaller and more variable than the ECM's (as observed empirically). On theoretical and practical grounds, the MRM is preferred to the ECM unless there are significant data errors