CRIEFF Discussion Paper Number 0303
Production and Hedging Decisions in the Presence of Basis Risk: Note
Moavia Alghalith
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Abstract
Paroush and Wolf (1989) modeled output hedging in the presence of basis risk.
They showed that (in the absence of scale shift) the optimal hedging and
output fall in response to basis risk. However, they used a second-order
Taylor's approximation of the utility function. Also, they did not show the
impact of basis risk on the ratio of hedging to output (hedging as a fraction
of output), which is a more relevant variable than the absolute change in
either of the decision variables. The absence of such results constitutes
a major gap in the hedging literature.
Consequently, this note provides two extensions. First, it generalizes Paroush
and Wolf's results (Propositions 1 and 2) by using a general utility function
and general distributions. Second, it shows the impact of basis risk on the
ratio of hedging to output.
Key Words
Cost uncertainty, forward market, futures market, hedging, input
price uncertainty
JEL Classifications
D8
Moavia Alghalith
University of St Andrews
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