The impact of inflation risk on forward trading and production

Udo Broll and Kit Pong Wong

No 02/14, Dresden Discussion Paper Series in Economics from Technische Universität Dresden, Faculty of Business and Economics, Department of Economics

Abstract: This note examines the behavior of a competitive firm that faces joint price and inflation risk. Given that the price risk is negatively correlated with the inflation risk in the sense of expectation dependence, the firm optimally opts for an overhedge if the firm's coefficient of relative risk aversion is everywhere no greater than unity. Furthermore, banning the firm from forward trading may induce the firm to produce more or less, depending on whether the price risk premium is positive or negative, respectively. While the price risk premium is unambiguously negative in the absence of the inflation risk, it is not the case when the inflation risk prevails. In contrast to the conventional wisdom, forward hedging needs not always promote production should firms take in inflation seriously.

Keywords: Forward markets; Expectation dependence; Inflation risk; Production (search for similar items in EconPapers)
JEL-codes: D21 D24 D81 (search for similar items in EconPapers)
Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:tuddps:0214

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