Production and Hedging with Optimism and Pessimism under Ambiguity

Posted: 8 Aug 2014 Last revised: 30 Apr 2017

See all articles by Donald D. Lien

Donald D. Lien

University of Texas at San Antonio - College of Business - Department of Economics

Chia-Feng (Jeffrey) Yu

University of Adelaide - Business School; Financial Research Network (FIRN)

Date Written: January 11, 2017

Abstract

This paper analyzes the optimal production and hedging decisions of a competitive firm holding optimism and pessimism under price ambiguity. We show that the separation theorem remains intact as the firm's optimal output level depends neither on the output price distribution nor on the firm's preferences. Furthermore, the validity of the full-hedging theorem depends on the extent to which the firm is optimistic about the uncertain output price. Notably, we identify a threshold of the firm's optimism level above which it is never optimal for the firm to full-hedge even when an unbiased hedging opportunity is available. Our results suggest how a firm's optimism level and ambiguity degree affect its production and hedging behavior and provide a novel explanation for why firms in practice shy away from full-hedging.

Keywords: Price Ambiguity, Optimism, Pessimism, Production, Hedging

JEL Classification: D92, G02, G32

Suggested Citation

Lien, Donald and Yu, Chia-Feng (Jeffrey), Production and Hedging with Optimism and Pessimism under Ambiguity (January 11, 2017). International Review of Economics & Finance, Vol. 50, 2017. Available at SSRN: https://ssrn.com/abstract=2476883 or http://dx.doi.org/10.2139/ssrn.2476883

Donald Lien

University of Texas at San Antonio - College of Business - Department of Economics ( email )

6900 North Loop 1604 West
San Antonio, TX 78249
United States
210-458-4313 (Phone)
210-458-4308 (Fax)

Chia-Feng (Jeffrey) Yu (Contact Author)

University of Adelaide - Business School ( email )

10 Pulteney Street
Adelaide, SA 5005
Australia
+61-08-83132073 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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