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A company has to hold an underlying asset for one year and it is looking to use Brent Crude futures to hedge against changes in the underlying asset's price.

  1. Assuming there is no liquidity concerns in Brent Crude futures of all expiries, would it always make more sense to match the maturity of the futures and the underlying asset? (i.e. taking short position in one-year futures in this case). Or, for example if the 3-month futures show the highest $R^2$ between the futures' and underlying asset's historical price changes, are you willing to engage in a rolling hedge even when it means additional basis risk every time you rollover?

  2. In running the regression of futures' and the underlying asset's price changes to estimate the optimal hedge ratio, is it better to use daily, weekly or monthly price? What is the most common industry practice and is there any justification for that?

Thank you so much in advance!

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What you call additional basis risk is unpredictable. It may win or lose in rolling strategy against buying 1 year futures once. But what is measurable is bid/offer spread. In 1 y contract it might be significantly wider that in quarter futures, even considering that you sell 4 times and buy 3 (lose 7 half spreads).

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  • $\begingroup$ Thank you for the reply. I definitely understand the higher bid-ask issue caused by lower liquidity of longer-term contracts. I just thought that Brent Crude is so often traded it would not be an issue. $\endgroup$ – Kix111 Aug 25 '16 at 0:51
  • $\begingroup$ Yes, I think you're right. $\endgroup$ – plkn Aug 25 '16 at 7:40
  • $\begingroup$ I see that today Aug17 Brent traded 538 contracts versus 190000 contracts for Nov16, so yes, liquidity could be an issue. $\endgroup$ – noob2 Aug 25 '16 at 21:42
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  1. Always use the prompt contract when hedging an asset. deferred months can move opposite to the prompt contact on occasion.
  2. Use whatever time period you are using to value the asset. If you are using Brent to hedge it then it likely has daily exposure so you would want to use daily price.
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