On the optimal mix of corporate hedging instruments: Linear versus nonlinear derivatives

We examine how corporations should choose their optimal mix of linear and nonlinear derivatives. We present a model in which a firm facing both quantity (output) and price (market) risk maximizes its expected profits when subjected to financial distress costs. The optimal hedging position generally...

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Bibliographic Details
Published in:The journal of futures markets 2003-03, Vol.23 (3), p.217-239
Main Authors: Gay, Gerald D., Nam, Jouahn, Turac, Marian
Format: Article
Language:English
Subjects:
Costs
Derivatives
Economics
Enterprises
Expected utility
Finance
Firm value
Futures
Hedging
Mathematical models
Put & call options
Risk
Studies
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Summary:We examine how corporations should choose their optimal mix of linear and nonlinear derivatives. We present a model in which a firm facing both quantity (output) and price (market) risk maximizes its expected profits when subjected to financial distress costs. The optimal hedging position generally is comprised of linear contracts, but as the levels of quantity and price‐risk increase, the use of linear contracts will decline due to the risks associated with overhedging. At the same time, a substitution effect occurs toward the use of nonlinear contracts. The degree of substitution will depend on the correlation between output levels and prices. Our model also allows us to provide insight into the relation between a firm's derivatives usage and its transaction‐cost structure. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:217–239, 2003
ISSN:0270-7314
1096-9934
DOI:10.1002/fut.10061