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Hedging under counterparty credit uncertainty

✍ Scribed by Olivier Mahul; J. David Cummins

Publisher
John Wiley and Sons
Year
2008
Tongue
English
Weight
305 KB
Volume
28
Category
Article
ISSN
0270-7314

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✦ Synopsis

Abstract

This study investigates optimal production and hedging decisions for firms facing price risk that can be hedged with vulnerable contracts, i.e., exposed to nonhedgeable endogenous counterparty credit risk. When vulnerable forward contracts are the only hedging instruments available, the firm's optimal level of production is lower than without credit risk. Under plausible conditions on the stochastic dependence between the commodity price and the counterparty's assets, the firm does not sell its entire production on the vulnerable forward market. When options on forward contracts are also available, the optimal hedging strategy requires a long put position. This provides a new rationale for the hedging role of options in the over‐the‐counter markets exposed to counterparty credit risk. Β© 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28: 248–263, 2008

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