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Ambiguity and the Value of Hedging

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  • Kit Pong Wong

Abstract

This paper examines the optimal production and hedging decisions of the competitive firm under price uncertainty when the firm's preferences exhibit smooth ambiguity aversion and an unbiased forward hedging opportunity is available. Ambiguity is modeled by a second‐order probability distribution that captures the firm's uncertainty about which of the subjective beliefs govern the price risk. Ambiguity preferences are modeled by the (second‐order) expectation of a concave transformation of the (first‐order) expected utility of profit conditional on each plausible subjective distribution of the price risk. Within this framework, the separation and full‐hedging theorems remain intact. Banning the firm from trading its output forward at the unbiased forward price has adverse effect on the firm's production decision. The firm finds the unbiased forward hedging opportunity more valuable in the presence than in the absence of ambiguity. Furthermore, the value of hedging increases when the firm's beliefs are more ambiguous, or when the firm becomes more ambiguity averse. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:839–848, 2015

Suggested Citation

  • Kit Pong Wong, 2015. "Ambiguity and the Value of Hedging," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 35(9), pages 839-848, September.
  • Handle: RePEc:wly:jfutmk:v:35:y:2015:i:9:p:839-848
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    Cited by:

    1. Simon Quemin, 2016. "Intertemporal abatement decisions under ambiguity aversion in a cap and trade," Working Papers 1604, Chaire Economie du climat.
    2. repec:spr:eurase:v:8:y:2018:i:3:d:10.1007_s40822-018-0096-2 is not listed on IDEAS
    3. repec:eee:reveco:v:50:y:2017:i:c:p:122-135 is not listed on IDEAS
    4. Kit Pong Wong, 2015. "A Smooth Ambiguity Model Of The Competitive Firm," Bulletin of Economic Research, Wiley Blackwell, vol. 67(S1), pages 97-110, December.
    5. Wong, Kit Pong, 2016. "Ambiguity and the multinational firm," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 404-414.
    6. repec:eee:joecas:v:12:y:2015:i:2:p:190-196 is not listed on IDEAS

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