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Risk management with default-risky forwards

Author

Listed:
  • Korn, Olaf

Abstract

This paper studies the impact of counter-party default risk of forward contracts on a firm's production and hedging decisions. Using a model of a risk-averse competitive firm under price uncertainty, it derives several fundamental results. If expected profits from forward contracts are zero, the hedge ratio is surprisingly not affected by default risk under general preferences and general price distributions. This robustness result still holds if forwards are subject to additional basis risk. In general, the analysis shows that default risk is no valid reason to reduce hedge ratios if the size of a firm's forward position does not affect the counter-party's default probability. However, a firm's optimal output is negatively affected by default risk and it is generally advisable to hedge default risk with credit derivatives.

Suggested Citation

  • Korn, Olaf, 2008. "Risk management with default-risky forwards," CFR Working Papers 08-11, University of Cologne, Centre for Financial Research (CFR).
    • Handle: RePEc:zbw:cfrwps:0811
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    More about this item

    Keywords

    risk management; forwards; default risk; hedging; production;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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