Dynamic hedging of copper options

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School of Economics | Master's thesis
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OBJECTIVES OF THE STUDY The objective of this thesis is to study the pricing of copper options by comparing the premiums of traded options and delta hedging cost. Furthermore, this thesis analyzes the profits of using options in the copper price risk management of an industrial company that uses copper as a raw material. Delta hedging of options and option returns have been widely studied in equity markets but relatively few studies have been conducted in the commodity markets. This paper thus extends on the literature concerning commodity options. DATA AND METHODOLOGY The data set consists of prices of traded copper forwards and options of 6 different maturities in London Metal Exchange in 1998-2008. Delta hedging is conducted with both the basic Black (1976) model and with a GARCH application to account for stochastic volatility in the underlying instrument. In addition, the delta hedging returns are regressed on simultaneous copper returns to account for systematic bias in the hedge ratios. The returns are also analyzed against the performance of the S&P 500 Composite Index, the US Government Bond Index, the GSCI, as well as the SMB and HML factors. The profitability of using traded options in risk management is assessed by comparing the returns of long positions in copper forwards and options. Furthermore, in a second strategy the term structure of copper is used to select a position in a forward or an option. RESULTS This study finds evidence on the cost of delta hedging being lower than the premiums traded options in the copper market. The application of GARCH volatility does not influence profits of delta hedging further, but reduces the deviation of returns slightly. Overall, the returns on delta hedging are not related to copper returns or systematic market risk factors. Due to their high price, traded options are not optimal in risk management over the observance period. Furthermore, using copper term structure to choose between a forward or an option does not affect the cost of risk management.
Commodity options, delta hedging, risk management, GARCH volatility