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Backwardation and Optimal Hedging Demand in an Expected Utility Hedging Model

In: Microeconomic Risk Management and Macroeconomic Stability

Author

Listed:
  • Andreas Röthig

    (Darmstadt University of Technology)

Abstract

Most recent models on optimal hedging deal with exporting firms facing price or exchange rate risk. In order to hedge the spot commitment, firms go short in futures contracts.1 This hedging literature, dealing with exporting firms hedging short, unequivocally suggests a negative relation between backwardation and the size of the optimal short hedging position.2 In sum, the literature suggests that if the futures market is characterized by backwardation (contango), it is optimal for the short hedger to underhedge (overhedge), where underhedging (overhedging) means choosing a futures position smaller (larger) than the initial spot commitment. In the absence of backwardation or contango, the firm hedges fully, and therefore chooses the futures position to be the same size as the spot position.3 Hence, an increase in backwardation should, ceteris paribus, reduce the trading volume of hedgers in short futures contracts.

Suggested Citation

  • Andreas Röthig, 2009. "Backwardation and Optimal Hedging Demand in an Expected Utility Hedging Model," Lecture Notes in Economics and Mathematical Systems, in: Microeconomic Risk Management and Macroeconomic Stability, chapter 0, pages 15-30, Springer.
    • Handle: RePEc:spr:lnechp:978-3-642-01565-6_2
    DOI: 10.1007/978-3-642-01565-6_2
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