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Corporate Hedging In Incomplete Markets: A Solution Under Price Transmission

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  • Luo, Rui
  • Fortenbery, T. Randall

Abstract

This paper provides dynamic minimum-variance hedges for firms in incomplete markets. Our hedges accounts for price transmission between the input and output prices, and thereby enable firms to minimize both input and output price fluctuations through tradable securities. Specifically, the model conditions on the direction and magnitude of price transaction between raw materials and products, as well as on the availability of futures contracts. A two-factor diffusion model is assumed for the underlying asset. The optimal hedges are the weighted average of the classic direct hedging and cross hedging ratios. We apply our results to the problem of a hypothetical jet fuel producer. Empirical results demonstrate the hedging effectiveness of this model.

Suggested Citation

  • Luo, Rui & Fortenbery, T. Randall, 2017. "Corporate Hedging In Incomplete Markets: A Solution Under Price Transmission," 2017 Conference, April 24-25, 2017, St. Louis, Missouri 285879, NCR-134/ NCCC-134 Applied Commodity Price Analysis, Forecasting, and Market Risk Management.
    • Handle: RePEc:ags:n13417:285879
    DOI: 10.22004/ag.econ.285879
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