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Production and hedging under Knightian uncertainty

✍ Scribed by Lien, Donald

Publisher
John Wiley and Sons
Year
2000
Tongue
English
Weight
156 KB
Volume
20
Category
Article
ISSN
0270-7314

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✦ Synopsis

This article introduces Knightian uncertainty into the production and futures hedging framework. The firm has imprecise information about the probability density function of spot or futures prices in the future. Decision-making under such scenario follows the "max-min" principle. It is shown that inertia in hedging behavior prevails under Knightian uncertainty. In a forward market, there is a region for the current forward price within which full hedge is the optimal hedging policy. This result may help explain why the one-to-one hedge ratio is commonly observed. Also inertia increases as the ambiguity with the probability density function increases. When hedging on futures markets with basis risk, inertia is established at the regression hedge ratio. Moreover, if only the futures price is subject to Knightian uncertainty, the utility function has no bearing on the possibility of inertia.

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