Abstract
Many corporations in the developed world face price and quantity uncertainty in commodities for which there are traded assets -- futures and options contracts -- which permit these corporations to hedge the risk to which they are exposed. Finance research has demonstrated frictions in capital markets are equivalent to risk-averse decision-making: Accordingly, decision-makers may make optimal decisions based on a trade-off between risk and return. Theory indicates the optimal hedging program hinges on the amount of exposure the corporation wishes to hedge: As risk aversion increases the company's optimal hedge proceeds from no-hedging, to acquiring options, then to replacing options with futures contracts. Using data from the CFTC as well as gold companies, this paper provides an empirical test of whether corporations' hedge ratios are consistent with such optimal management of risk exposure using futures and/or options.
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