Optimal Hedging Policy Research Articles

Production and hedging under Knightian uncertainty

This article introduces Knightian uncertainty into the production and futures hedging framework. The firm has imprecise information about the probability density function of spot or futures prices in the future. Decision‐making under such scenario follows the “max‐min” principle. It is shown that inertia in hedging behavior prevails under Knightian uncertainty. In a forward market, there is a region for the current forward price within which full hedge is the optimal hedging policy. This result may help explain why the one‐to‐one hedge ratio is commonly observed. Also inertia increases as the ambiguity with the probability density function increases. When hedging on futures markets with basis risk, inertia is established at the regression hedge ratio. Moreover, if only the futures price is subject to Knightian uncertainty, the utility function has no bearing on the possibility of inertia. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20: 397–404, 2000

Optimal Hedging and the Partial Loss Offset Provision

In this paper, we examine how taxation affects the optimal hedging behaviour of an investor exposed to price risk under partial loss offset provision. In this regime, only part of the loss is refunded through the tax. As such, it implies a non-linearity in the taxation schedule. More specifically, we look at an individual endowed with some fixed quantity of a commodity and facing a price risk. The optimal hedging policy is derived. The comparative statics of a tightening of the PLO provision and a changing risk aversion are analysed. We show that the response of the optimal hedging policy to a change in the tax rate can be signed by a preference free or a preference related sufficient condition, involving the notions of cost-of-carry and partial risk aversion.

Hedging policies for failure-prone manufacturing systems: optimality of JIT and bounds on buffer levels

The authors consider multiple part-type single-machine manufacturing systems subject to failures. They provide necessary and sufficient conditions for the optimality of just-in-time (JIT) manufacturing, and further show that the necessary and sufficient conditions coincide when the backlog costs for all the parts are equal. In general, finding optimal hedging policies for multiple part-type problems is extremely difficult. They provide bounds on the optimal hedging points and also prove that, under an optimal hedging policy, the buffer levels will be upper bounded.

Circulant preconditioners for failure prone manufacturing systems

This paper studies the application of preconditioned conjugate-gradient methods in solving for the steady-state probability distribution of manufacturing systems. We consider the optimal hedging policy for a failure prone one-machine system. The machine produces one type of product, and its demand has finite batch arrival. The machine states and the inventory levels are modeled as Markovian processes. We construct the generator matrix for the machine-inventory system. The preconditioner is constructed by taking the circulant approximation of the near-Toeplitz structure of the generator matrix. We prove that the preconditioned linear system has singular values clustered around one when the number of inventory levels tends to infinity. Hence conjugate-gradient methods will converge very fast when applied to solving the preconditioned linear system. Numerical examples are given to verify our claim. The average running cost for the system can be written in terms of the steady state probability distribution. The optimal hedging point can then be obtained by varying different values of the hedging point.

Does Hedging Aggravate or Alleviate Agency Problems? A Managerial Theory of Risk Management

This paper investigates how corporate risk management policy and managerial compensation contracts are jointly determined when hedging policy can be a source of agency problems. The optimal hedging policy and stock-based compensation contract are characterized in terms of the firm's abandonment (liquidation) value, its profitability, and the extent of its risk exposure. The basic tradeoff is between the efficiency of managerial effort and that of the firm?s abandonment option. The recognition of the loss of abandonment option value as an economic cost of hedging has implications for why firms hedge less long term exposure, why hedging is necessary for incentive purposes even when compensation contracts are allowed to be dependent on the variables being hedged, why firms seem to be more concerned with the downside risk and how the downside risk should be measured, and why disclosing the market value of hedging instruments can undermine hedging. The model yields joint testable predictions for hedging policy and the form of compensation contracts. The paper also identifies conditions under which welfare will be improved if hedging can be prohibited.

Corporate Incentives for Hedging and Hedge Accounting

This article explores the information effect of financial risk management. Financial hedging improves the informativeness of corporate earnings as a signal of management ability and project quality by eliminating extraneous noise. Managerial and shareholder incentives regarding information transmission may differ, however, leading to conflicts regarding an optimal hedging policy. We show that these incentives depend on the accounting information made available by the firm. Under some circumstances, if hedge transactions are not disclosed (i.e., firms report only aggregate earnings), managers hedge to achieve greater risk reduction than they would if full disclosure were required. In these cases, it is optimal for shareholders to request only aggregate accounting reports. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

The Behavior of Flexible Exchange Rates: Evidence and Implications

for predicting currency price movements. Furthermore, variations in nominal exchange rates are dominated by changes in real rates. Past rate changes will not be useful for predicting inflation, or vice versa. Changes in money supplies, real incomes, interest rates and current or trade accounts appear not to be systematically related to changes in exchange rates. In the absence of any systematic component that could be exploited for forecasting purposes, what means are available for controlling exchange rate risk? Hedging can be used with some effect, but the optimal hedging policy is still a matter of debate. Given the relatively low correlations between Euromarket interest rates and returns on common stock indexes and relative changes in exchange rates, diversification across international markets offers considerable potential for risk reduction.

Optimal Hedging Policies

This paper makes contributions in two directions. First, the paper presents a model in which value-maximizing firms pursue active hedging policies. Second, the paper derives optimal hedging policies for risk-averse agents. Whereas the methodology used and the results provided are quite general, this paper deliberately focuses the analysis on hedging foreign exchange exposure through forward contracts on foreign currencies. This emphasis is explained by the fact that hedging foreign currency exposure through forward contracts has been a topic of considerable interest in recent years.