Hedging and the regret theory of the firm

Abstract

This paper examines the production and hedging decisions of the competitive firm under price uncertainty when the firm is not only risk averse but also regret averse. Regret-averse preferences are characterized by a modified utility function that includes disutility from having chosen ex post suboptimal alternatives. The extent of regret depends on the difference between the actual profit and the maximum profit attained by making the optimal production, and hedging decisions had the firm observed the true realization of the random output price. While the separation theorem holds under regret aversion, the prevalence of hedging opportunities may have perverse effect on the firm’s optimal output level, particularly when the firm is sufficiently regret averse. The full-hedging theorem, however, does not hold. We derive sufficient conditions under which the regret-averse firm’s optimal futures position is an under-hedge (over-hedge). We further show that the firm optimally increases (decreases) its futures position when the price risk possesses more positive (negative) skewness.