Foreign Exchange

Combination hedging strategy based on input-output model and agent`s risk aversion: A Theoretical Analysis

Xun Di Diaoa , Chong Feng Wua

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Antai College of Economics & Management, Shanghai Jiao Tong University, 535 Fahuazhen Road, Shanghai 200052, PR China

Abstract. Most of existing literatures often suffer three problems in designing futures hedging models. First, they focus on hedging for one or multiple futures to one spot commodity. Second, no consideration is made on the relation between inflow and outflow during the process of production. Third, the risk of input prices and output prices are often independently considered. The paper makes up these shortages in view of three aspects: 1) build optimal decision-making models of hedging for multi-futures to multi-spot commodity; 2) introduce the model of Leontief input-output to make decision in the spot market. 3) simultaneously hedge for the prices risk of multi-input and multi-output. In addition, in order to take into account both risk and return, we introduce Von Neumann-Morgenstern utility function with exponential form as an objective to be optimized. Aiming to maximize the expected utility, some mathematical and analytical methods are formed to explicitly solve the class of optimal problems.

Keywords: Commodity futures; combination hedging; input-output; risk aversion

1. Introduction Until now, both academicians and practitioners have shown great interest in the issue of hedging by use of derivative securities such as futures contracts. There are a large number of articles written in this area in view of models and methodology. Generally, no hedging mechanism exists in spot markets; and contracts markets can provide a kind tool to hedge all kinds of risks. The futures markets provide perhaps the most important risk-sharing institution to producers, and as a result the analyses of optimal hedging decisions have been the object of considerable research (Moschini and Lapan, 1995). The basic...