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Hedging and the competitive firm under correlated price and background risk

Abstract

This paper examines the behavior of the competitive firm under correlated price and background risk when a futures market exists for hedging purposes. We show that imposing the background risk, be it additive or multiplicative, on the firm has no effect on the separation theorem. The full-hedging theorem, however, holds if the background risk is independent of the price risk. In the general case of the correlated price and background risk, we adopt the concept of expectation dependence to describe the bivariate dependence structure. When the background risk is additive, the firm finds it optimal to opt for an over-hedge or an under-hedge, depending on whether the price risk is positively or negatively expectation dependent on the background risk, respectively. When the background risk is multiplicative, both the concept of expectation dependence and the Arrow–Pratt measure of relative risk aversion are called for to determine the firm’s optimal futures position.

I would like to thank Paolo Ghirardato (the Editor-in-Chief), Frank Riedel (the Associate Editor), and an anonymous referee for their helpful comments and suggestions. The usual disclaimer applies.