Risk Minimizing Hedging of Crude-Oil Options : Theory and Empirical Performance

We study the hedging problem for European-style options written on crude-oil futures. Locally risk-minimizing hedging strategies are derived under the assumption that the dynamics of crude-oil futures are described by a Merton-type jump-diffusion. These are then tested empirically using historical data from the NYMEX West Texas Intermediate (WTI) from the 2002-2007 period. We use Black-Scholes-Merton delta hedges as a benchmark for comparison and find that in crude-oil option markets locally risk-minimizing hedges systematically outperform the benchmark by a margin of 13%-18%. In addition to this real world performance test, we also investigate hedging strategies for robustness against model uncertainty and mis-specification, using simulated data. Our results show that locally risk minimizing strategies are much more robust than its classical alternatives