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The impact of inflation risk on forward trading and production

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  • Udo Broll
  • Kit Wong

Abstract

This paper examines the behavior of a competitive firm that faces joint price and inflation risk. Given that the price risk is negatively correlated with the inflation risk in the sense of expectation dependence, we show that the firm optimally opts for an over-hedge (under-hedge) if the firm’s coefficient of relative risk aversion is everywhere no greater (no smaller) than unity. We show further that banning the firm from forward trading may induce the firm to produce more or less, depending on whether the price risk premium is positive or negative, respectively. While the price risk premium is unambiguously negative in the absence of the inflation risk, it is not the case when the inflation risk prevails. In contrast to the conventional wisdom, forward hedging needs not always promote production should firms take inflation seriously. Copyright ISEG 2015

Suggested Citation

  • Udo Broll & Kit Wong, 2015. "The impact of inflation risk on forward trading and production," Portuguese Economic Journal, Springer;Instituto Superior de Economia e Gestao, vol. 14(1), pages 65-73, December.
    • Handle: RePEc:spr:portec:v:14:y:2015:i:1:p:65-73
    DOI: 10.1007/s10258-015-0109-y
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    References listed on IDEAS

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    1. Kit Pong Wong, 2012. "Production and hedging under state‐dependent preferences," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(10), pages 945-963, October.
    2. Li, Jingyuan, 2011. "The demand for a risky asset in the presence of a background risk," Journal of Economic Theory, Elsevier, vol. 146(1), pages 372-391, January.
    3. Battermann, Harald L & Broll, Udo, 2001. "Inflation Risk, Hedging, and Exports," Review of Development Economics, Wiley Blackwell, vol. 5(3), pages 355-362, October.
    4. Kit Pong Wong, 2013. "A Note on Exports and Hedging Exchange Rate Risks: The Multi‐Country Case," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 33(12), pages 1191-1196, December.
    5. Holthausen, Duncan M, 1979. "Hedging and the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 69(5), pages 989-995, December.
    6. Harald L. Battermann & Udo Broll, 2001. "Inflation Risk, Hedging, and Exports," Review of Development Economics, Wiley Blackwell, vol. 5(3), pages 355-362, October.
    7. Sandmo, Agnar, 1971. "On the Theory of the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 61(1), pages 65-73, March.
    8. Udo Broll & Peter Welzel & Kit Wong, 2015. "Futures hedging with basis risk and expectation dependence," International Review of Economics, Springer;Happiness Economics and Interpersonal Relations (HEIRS), vol. 62(3), pages 213-221, September.
    9. Cuadras, C. M., 2002. "On the Covariance between Functions," Journal of Multivariate Analysis, Elsevier, vol. 81(1), pages 19-27, April.
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    Cited by:

    1. 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.

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    More about this item

    Keywords

    Forward hedging; Expectation dependence; Inflation risk; Production; D21; D24; D81;
    All these keywords.

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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