Abstract:

Substantial academic research has explained why firms should hedge,
but little work has addressed how firms should hedge. We assume
that firms face costly states of nature and derive optimal hedging
strategies using vanilla derivatives (e.g., forwards and options)
and custom "exotic" derivative contracts for a value-maximizing
firm that faces both hedgable (price) and unhedgable (quantity)
risks. Optimal hedges depend critically on price and quantity
volatilities, the correlation between price and quantity, and
profit margin. A close relationship exists between the optimal
number of forward contracts and the optimal custom hedge:
At the forward price of the traded good, the optimal forward hedge
and the optimal exotic hedge have identical "deltas". At prices
different from the forward price, the exotic contract fine-tunes
the firm's exposure by including a non-linear payoff component.
We also determine the benefits from choosing customized exotic
derivatives over vanilla contracts for different types of firms.
Customized exotic derivatives are typically better than vanilla
contracts when correlations between prices and quantities are large
in magnitude and when quantity risks are substantially greater
than price risks.