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Hedging under counterparty credit uncertainty

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  • Olivier Mahul
  • J. David Cummins

Abstract

This study investigates optimal production and hedging decisions for firms facing price risk that can be hedged with vulnerable contracts, i.e., exposed to nonhedgeable endogenous counterparty credit risk. When vulnerable forward contracts are the only hedging instruments available, the firm's optimal level of production is lower than without credit risk. Under plausible conditions on the stochastic dependence between the commodity price and the counterparty's assets, the firm does not sell its entire production on the vulnerable forward market. When options on forward contracts are also available, the optimal hedging strategy requires a long put position. This provides a new rationale for the hedging role of options in the over‐the‐counter markets exposed to counterparty credit risk. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28: 248–263, 2008

Suggested Citation

  • Olivier Mahul & J. David Cummins, 2008. "Hedging under counterparty credit uncertainty," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 28(3), pages 248-263, March.
    • Handle: RePEc:wly:jfutmk:v:28:y:2008:i:3:p:248-263
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    Cited by:

    1. Peter Carayannopoulos & Olga Kanj & M. Fabricio Perez, 2022. "Pricing dynamics in the market for catastrophe bonds," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan;The Geneva Association, vol. 47(1), pages 172-202, January.
    2. Korn, Olaf & Rieger, Marc Oliver, 2016. "Hedging with regret," CFR Working Papers 16-06, University of Cologne, Centre for Financial Research (CFR).
    3. Korn, Olaf & Merz, Alexander, 2016. "How to hedge if the payment date is uncertain?," CFR Working Papers 07-14 [rev.], University of Cologne, Centre for Financial Research (CFR).
    4. Korn, Olaf & Rieger, Marc Oliver, 2019. "Hedging with regret," Journal of Behavioral and Experimental Finance, Elsevier, vol. 22(C), pages 192-205.
    5. Olaf Korn & Alexander Merz, 2019. "How to hedge if the payment date is uncertain?," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(4), pages 481-498, April.

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