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On the optimal mix of corporate hedging instruments: Linear versus nonlinear derivatives
Author(s) -
Gay Gerald D.,
Nam Jouahn,
Turac Marian
Publication year - 2003
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.10061
Subject(s) - financial distress , substitution (logic) , economics , econometrics , position (finance) , nonlinear system , transaction cost , microeconomics , database transaction , computer science , finance , physics , quantum mechanics , financial system , programming language
Abstract We examine how corporations should choose their optimal mix of linear and nonlinear derivatives. We present amodel in which a firm facing both quantity (output) and price (market) risk maximizes itsexpected profits when subjected to financial distress costs. The optimal hedging position generally is comprisedof linear contracts, but as the levels of quantity and price‐risk increase, the use of linear contractswill decline due to the risks associated with overhedging. At the same time, a substitution effect occurs towardthe use of nonlinear contracts. The degree of substitution will depend on the correlation between output levelsand prices. Our model also allows us to provide insight into the relation between a firm's derivativesusage and its transaction‐cost structure. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark23:217–239, 2003