Analysis of cointegration for WTI and Brent Spot and Futures Prices and Their Hedging Performance

Abstract

This study investigates cointegration tendency in West Texas Intermediate (WTI) and Brent prices, which are the international major crude oil markets in the US and Europe, respectively and have well- established spot and futures markets. We verify the presence of cointegration among four variables, namely, WTI spot, WTI futures, Brent spot, and Brent futures, after establishing integration of order one over the time from 2000 to 2019. We confirm two structural breaks that take place in Aug 19, 2002 and May 26, 2016 through the Gregory-Hansen test. With the structural breaks, we divide the full sample into three sub-periods, (i) 2000 to 2002, (ii) 2002 to 2016, and (iii) 2016 to 2019. We then identify that the highest cointegration is exhibited during the sub-period (i), followed by the least cointegration in the sub-period (ii), and the sub-period (iii) depicts medium cointegration relation for all the pairs of the variables considered. Moreover, we perform dynamic delta hedging simulation on an European call option with underlying asset of WTI spot price compared to the one with cross hedging using Brent. Finally, we illustrate that cross hedging during the sub-period with the highest cointegration results in total positive profit and the least gap in the highest profit and loss.