Futures hedging with basis risk and expectation dependence

Udo Broll (), Peter Welzel () and Kit Wong ()

International Review of Economics, 2015, vol. 62, issue 3, 213-221

Abstract: This paper examines the behavior of the competitive firm under price uncertainty. The firm has access to a futures market for hedging purposes. Basis risk exists because the random spot and futures prices are not identical at the time when the futures contracts mature. We show that the firm optimally produces less in the presence than in the absence of the basis risk. Furthermore, we demonstrate that the concept of expectation dependence that describes how the basis risk is correlated with either the random spot price or the random futures price plays a pivotal role in determining the firm’s optimal futures position. Specifically, an under-hedge is optimal if either the random spot price or the random futures price is negatively expectation dependent on the basis risk. On the other hand, an over-hedge is optimal if the random futures price is positively expectation dependent on the basis risk. The firm’s optimal futures position becomes indeterminate if the random spot price is positively expectation dependent on the basis risk. Copyright Springer-Verlag Berlin Heidelberg 2015

Keywords: Basis risk; Hedging; Production; Expectation dependence; D21; D81; G13 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (5)

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DOI: 10.1007/s12232-015-0240-1

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