Risk management with default-risky forwards

Olaf Korn

No 08-11, CFR Working Papers from University of Cologne, Centre for Financial Research (CFR)

Abstract: This paper studies the impact of counter-party default risk of forward contracts on a firm's production and hedging decisions. Using a model of a risk-averse competitive firm under price uncertainty, it derives several fundamental results. If expected profits from forward contracts are zero, the hedge ratio is surprisingly not affected by default risk under general preferences and general price distributions. This robustness result still holds if forwards are subject to additional basis risk. In general, the analysis shows that default risk is no valid reason to reduce hedge ratios if the size of a firm's forward position does not affect the counter-party's default probability. However, a firm's optimal output is negatively affected by default risk and it is generally advisable to hedge default risk with credit derivatives.

Keywords: risk management; forwards; default risk; hedging; production (search for similar items in EconPapers)
JEL-codes: D81 G30 (search for similar items in EconPapers)
Date: 2008
References: View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.econstor.eu/bitstream/10419/41350/1/591502763.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:zbw:cfrwps:0811

Access Statistics for this paper

More papers in CFR Working Papers from University of Cologne, Centre for Financial Research (CFR) Contact information at EDIRC.
Bibliographic data for series maintained by ZBW - Leibniz Information Centre for Economics ().