On the Optimal Mix of Corporate Hedging Instruments: Linear Versus Non-Linear Derivatives

Abstract

We examine how corporations should choose their optimal mix of linear and non-linear derivatives. We present a model in which a firm facing both quantity (output) and price (market) risk maximizes its expected profits when subject to financial distress costs. The optimal hedging position generally is comprised of linear contracts, but as the levels of quantity and price risk increase, the use of linear contracts will decline due to the risks associated with over-hedging. At the same time, a substitution effect occurs towards the use of non-linear contracts. The degree of substitution will depend on the correlation between output levels and prices. Our model also allows us to provide insight into the relation between a firm's derivatives usage and its transaction-cost structure.

Keywords: Derivatives, Financial Risk Management, Hedging

JEL Classification: G10, G13, G30, L25