Marketable and non-hedgeable risk in a duopoly framework with hedging

Abstract

Today’s volatile markets make the issue of hedging risk more important than ever. The purpose of this paper is to contribute to the growing body of literature on corporate hedging and to investigate the duopoly case under multiple uncertainty. We model a framework with marketable as well as non-hedgeable risk and derive optimal financial risk management decisions under (μ, σ)-preferences. We study two settings: First, we consider the case of additive background risk. It is shown that production and the Nash-equilibrium are not affected by the background risk and the separation theorem is valid in this case. Second, multiplicative technological risk is analyzed. We show that the multiplicative version of the non-hedgeable risk violates the separation property and the market equilibrium depends on the stochastic dependence of the marketable and the non-hedgeable risk. In both settings, primarily the stochastic dependence of the two risks affects the hedging decision.