his article examines an individual's demand for hedging instruments (forward con-T tracts, futures contracts, and commodity bonds) and analyzes how the demand for a hedging instrument is affected by: the instrument's price, the hedger's wealth, and the degree of risk aversion desired.
The main feature of a hedging instrument is a perfect correlation between its return and the price of some consumption good. It differs from the risky asset analyzed by Arrow (1972) where the returns are stocastically independent of the prices of consumption goods.
This article shows that, under some restrictions, the effects of the investor-consumer's wealth and the price of the hedging instrument on the demand (for the hedging instrument) are similar to those in the independence case (of Arrow). However, the effect of an increase in risk aversion may be different. Such an increase always reduces investment in the risky asset when the return on the asset and the prices of consumption goods are independent. But it can increase the demand for a hedging instrument by an individual who has a long position, because of the insurance the instrument provides.
There exists another important difference between the two cases. The demand for a risky asset in the independence case vanishes when the price of the asset equals its expected return. By contrast, the demand for a hedging instrument under the same conditions could be positive, zero, or negative depending on the difference between the relative measure of risk aversion and the income elasticity of demand for the product whose price is correlated with the returns on the hedging instrument.
THE MODEL
Consider a risk-averse individual who consumes two goodsan all-purpose good X,