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

32 Pages Posted: 12 Oct 2002

See all articles by Gerald D. Gay

Gerald D. Gay

Georgia State University - Department of Finance

Jouahn Nam

Pace University - Lubin School of Business

Marian Turac

Oklahoma State University - Stillwater - Department of Finance

Date Written: July 24, 2002

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

Suggested Citation

Gay, Gerald D. and Nam, Jouahn and Turac, Marian, On the Optimal Mix of Corporate Hedging Instruments: Linear Versus Non-Linear Derivatives (July 24, 2002). Available at SSRN: https://ssrn.com/abstract=322880 or http://dx.doi.org/10.2139/ssrn.322880

Gerald D. Gay (Contact Author)

Georgia State University - Department of Finance ( email )

Robinson College of Business
Atlanta, GA 30303-3083
United States
404-413-7321 (Phone)
404-413-7312 (Fax)

Jouahn Nam

Pace University - Lubin School of Business ( email )

1 Pace Plaza
New York, NY 10038-1502
United States
212-346-1818 (Phone)
212-346-1573 (Fax)

Marian Turac

Oklahoma State University - Stillwater - Department of Finance ( email )

North Hall 323
700 N. Greenwood Avenue
Tulsa, OK 74106
United States
918-594-8258 (Phone)
918-594-8281 (Fax)

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