Optimal Corporate Hedging Using Options with Basis and Production Risk
North American Journal of Economics and Finance, Vol. 30, pp. 56-71, 2014
Posted: 29 Aug 2014 Last revised: 13 May 2015
Date Written: August 18, 2014
We investigate the optimal hedging strategy for a firm using options, where the role of production and basis risk are considered. Contrary to the existing literature, we find that the exercise price which minimizes the shortfall of the hedged portfolio is primarily affected by the amount of cash spent on the hedging. Also, we decompose the effect of production and basis risk showing that the former affects hedging effectiveness while the latter drives the choice of the optimal contract. Fitting the model parameters to match a financial turmoil scenario confirms that suboptimal option moneyness leads to a non-negligible economic loss.
Keywords: Risk management, Option hedging, Expected shortfall
JEL Classification: G30, G32
Suggested Citation: Suggested Citation