How Does “Cost Risk”Influence Producers' Decision to Hedge?

Several studies have investigated transaction costs in futures trading and found that optimal hedge ratios tend to be smaller in their presence. However, those studies consider transaction costs deterministically, i.e. hedgers know the exact amount of transaction costs when the hedge is placed. The current research relies on the notion that some transaction costs are uncertain when the producer decides to place a hedge. The uncertainty originates from the fact that some costs, such as margin deposits and taxation, depend on the trajectory of futures prices during the hedging period. The objective of the paper is to investigate how the uncertainty associated with transactions costs can influence producers’ decision to hedge. In addition, a broader range of costs involved in hedging operations will be introduced. Two main results emerge from this study. First, consistent with previous studies, introduction of transaction costs in futures trading leads to smaller hedge ratios. Second, allowing for uncertainty in transaction costs does not seem to have a larger impact on hedge ratios. In fact, the introduction of stochastic transactio