A Study Of Prospect-theory-embedded Dynamic Risk Aversion Hedge Ratio Model

One of the important functions of futures markets is to avoid price risks through hedge. How to determine the optimal hedge ratio in hedge operation is the core technical problem. The so-called hedge ratio refers to the ratio of size of futures contractual position held by hedgers to the size of corresponding risk-exposed spot assets. The traditional minimum variance hedge ratio theory is based on the assumption that investors are rational investors who only take into account risk reducing, but not hedgers'risk aversion level or the profit they expect by adopting their hedge strategies. But the assumption rational investor is not true in real life.Following the prospect theory, the thesis adds the important element of risk aversion to discussion with the decision criteria to maximize the utility value, eliciting the dynamic risk aversion hedge ratio formula that embeds prospect theory. It makes empirical analysis of the sample of the average prices of copper spot and futures between August 20,2004 and June 4,2010. First, the market is divided into bear and bull, and the hedgers are divided into short hedgers and long hedgers. Their corresponding dynamic risk aversion coefficients are then calculated. Thirdly, the minimum variance hedge ratio and the dynamic risk aversion hedge ratio of the two kinds of hedges are calculated in different market conditions. Finally, the thesis compare the two ratios from the perspective of hedge effectiveness and utility maximization respectively in order to provide the hedgers with the optimal hedge strategies according to their individual needs. The results of empirical analysis show that:the levels of risk aversion are different between short hedgers and long hedgers, and risk aversion varies in different market conditions, and that different market conditions and dynamic risk aversion are two important factors in the hedge ratio, which should be taken into account in the calculation of hedge ratios.