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Production and futures hedging with state-dependent background risk

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  • Wong, Kit Pong

Abstract

This paper examines the production and futures hedging decisions of the competitive firm under output price uncertainty and with state-dependent background risk. We show that the firm's optimal production decision is independent of the underlying uncertainty and of the firm's risk attitude. We further show that the firm's optimal futures position is a full-hedge that completely eliminates the output price risk if either the background risk is state-independent, or the firm's utility function is quadratic. When the firm's preferences exhibit prudence, an under-hedge or an over-hedge is optimal should the magnitude of the background risk vary in a monotonic manner with changes in the realized state. When the prudent firm has access not only to the unbiased futures contracts but also to fairly priced options, we construct a reasonable example wherein the firm optimally includes the options in its hedge position. Hence, we offer a rationale for the hedging role of options, which is over and above that of futures, in the case of state-dependent background risk.

Suggested Citation

  • Wong, Kit Pong, 2012. "Production and futures hedging with state-dependent background risk," International Review of Economics & Finance, Elsevier, vol. 24(C), pages 177-184.
    • Handle: RePEc:eee:reveco:v:24:y:2012:i:c:p:177-184
    DOI: 10.1016/j.iref.2012.03.002
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    Cited by:

    1. Udo Broll & Soumyatanu Mukherjee, 2018. "The attitude of multinationals towards risks," Discussion Papers 2018-02, University of Nottingham, GEP.
    2. Wong, Kit Pong, 2013. "International trade and hedging under joint price and exchange rate uncertainty," International Review of Economics & Finance, Elsevier, vol. 27(C), pages 160-170.
    3. Wong, Kit Pong, 2017. "Production and hedging under state-dependent preferences and background risk," International Review of Economics & Finance, Elsevier, vol. 51(C), pages 527-534.
    4. Wong, Kit Pong, 2016. "Ambiguity and the multinational firm," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 404-414.
    5. Guo, Xu & Li, Jingyuan, 2016. "Confidence band for expectation dependence with applications," Insurance: Mathematics and Economics, Elsevier, vol. 68(C), pages 141-149.

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    More about this item

    Keywords

    Futures; Production; Prudence; State-dependent background risk;
    All these keywords.

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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