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The Impact of Price-Induced Hedging Behavior on Commodity Market Volatility

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  • Kauffman, Nathan S.
  • Hayes, Dermot J.
  • Lence, Sergio H.

Abstract

The utility maximization problem of a grain producer is formulated and solved numerically under prospect theory as an alternative to expected utility theory. Conventional theory posits that the optimal hedging position of a producer should not increase solely due to increases in the level of futures prices. However, a strong degree of positive correlation is apparent in the data. Our results show that with prospect theory serving as the underlying behavioral framework, the optimal hedge of a producer is affected by changes in futures price levels. The implications of this price-induced hedging behavior on spot prices and volatility are subsequently considered.

Suggested Citation

  • Kauffman, Nathan S. & Hayes, Dermot J. & Lence, Sergio H., 2011. "The Impact of Price-Induced Hedging Behavior on Commodity Market Volatility," ISU General Staff Papers 201107010700001004, Iowa State University, Department of Economics.
    • Handle: RePEc:isu:genstf:201107010700001004
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    Cited by:

    1. Jacobs, Keri & Li, Ziran & Hayes, Dermot, 2016. "Price Responses in Forward Contracting: Do We Limit The Upside And Expose The Downside?," ISU General Staff Papers 201601010800001017, Iowa State University, Department of Economics.
    2. Choe, Chongwoo & Lien, Donald & Yu, Chia-Feng (Jeffrey), 2015. "Optimal managerial hedging and contracting with self-esteem concerns," International Review of Economics & Finance, Elsevier, vol. 37(C), pages 354-367.

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