Production and futures hedging with state-dependent background risk

This paper examines the production and futures hedging decisions of the competitive firm under output price uncertainty and with state-dependent background risk. We show that the firm's optimal production decision is independent of the underlying uncertainty and of the firm's risk attitude. We further show that the firm's optimal futures position is a full-hedge that completely eliminates the output price risk if either the background risk is state-independent, or the firm's utility function is quadratic. When the firm's preferences exhibit prudence, an under-hedge or an over-hedge is optimal should the magnitude of the background risk vary in a monotonic manner with changes in the realized state. When the prudent firm has access not only to the unbiased futures contracts but also to fairly priced options, we construct a reasonable example wherein the firm optimally includes the options in its hedge position. Hence, we offer a rationale for the hedging role of options, which is over and above that of futures, in the case of state-dependent background risk. (C) 2012 Elsevier Inc. All rights reserved.