Production and hedging under state-dependent preferences

Abstract

This study examines the behavior of the competitive firm under output price uncertainty and state-dependent preferences. When there is a futures market for hedging purposes, the firm's optimal production decision is independent of the output price uncertainty and of the state-dependent preferences. If the futures contracts are unbiased, the firm's optimal futures position is an over-hedge or an under-hedge, depending on whether the firm is correlation averse or correlation loving, and on whether the output price is positively or negatively expectation dependent on the state variable. When the firm has access not only to the unbiased futures but also to fairly priced options, sufficient conditions are derived under which the firm's optimal hedge position includes both hedging instruments. This study thus establishes a hedging role of options, which is over and above that of futures, in the case of state-dependent preferences. © 2011 Wiley Periodicals, Inc.