As we enter the final module of my Financial Modeling class, students shift from building models to using them in a way that feels much closer to reality: commodity hedging. Up to this point, much of what we have done relies on structure:
- returns
- distributions
- regressions
- correlations
Hedging forces a different kind of thinking. Because in the real world, relationships between variables are not stable, synchronized, or even visible at first glance
They are messy. And often delayed.
A Simple Example with Big Implications
I have recently been looking at protein prices (e.g., feeder cattle) and oil prices, I started with a straightforward approach:
Weekly returns and contemporaneous correlations (same week). The result tells one story. See chart below.
This shows a massive oil demand decrease during Covid. On the other hand supply chain disruptions and panic buying made prices of protein go higher. This did not change until the Russian invasion of Ukraine that jolt the system backwards.
But there is an economic problem with that assumption: Why would changes in oil prices affect protein markets immediately? Costs, transportation, feed, energy inputs take time to work through the system.
So I introduced something very simple: a 2-week lag in oil returns and suddenly, the relationship changes dramatically.
The situation changes dramatically. Now oil becomes a cost driver, going into fertilizer, transportation, energy costs in general.
Why This Matters for Hedging
This is not just a statistical curiosity. It has direct implications for how we hedge.
If you hedge based on contemporaneous correlations you assume immediate transmission of shocks and you may conclude: “this hedge doesn’t work” or“there is no relationship”
But what if the relationship is real… just delayed?
Now your problem is not only the hedge but also the timing.
I want students to walk away with two ideas that go beyond formulas:
1. Correlations Are Not Constants, they move. They evolve. They break. A hedge that worked last year may not work today.
2. The World Has Frictions. Information, costs, and shocks do not propagate instantly, there are lags, passthroughs, adjustments.
Good modeling requires respecting that reality.
If your hedge is not working, ask yourself:
Is it wrong… or are you just early?
