Exploring the futures hedging possibilities for the Norwegian lumber market, using the U.S. market as a proxy. Testing the effectiveness of different minimum variance hedge ratio approaches

Abstract

This paper explores the possibility for a cabin producer to manage lumber price volatility by hedging with futures contracts. Our intention is to explore if the introduction of a futures market for lumber will provide Norwegian (and European) producers with a viable way to handle said volatility. With a set of simplifying assumptions, a minimum variance strategy is tested on an artificially constructed cabin producer to estimate the effectiveness of such a strategy. Estimating the minimum variance hedge position is done using two advanced autoregressive models, in addition to a simpler, unconditional model. The three approaches are compared in a segmented time-series to isolate the effectiveness prior to and after the price shock that came with the Covid-19 pandemic. The findings indicate that the hedging strategy has great potential of reducing the variance of the cash flows. Prior to the Covid-19 outbreak, the variance of the cash flows could have been reduced by almost 50 percent. In that period, all three estimation models achieved almost identical effectiveness, with all three being within three percentage points of each other. Following the Covid-19 outbreak, there is a greater spread between the approaches, with the surprise being that the simpler, unconditional model outperforms the autoregressive models. The inferior performance of the conditional models indicates a weakness in the models’ ability to estimate the optimal hedge position in times of sustained increased volatility.