RELAXING THE ASSUMPTIONS OF MINIMUM-VARIANCE HEDGING
By: Lence, Sergio H.
Lence, Sergio H., RELAXING THE ASSUMPTIONS OF MINIMUM-VARIANCE HEDGING, Journal of Agricultural and Resource Economics, Volume 21, Issue 1, July 1996, Pages 39-55
The most important minimum-variance hedging ration assumptions are (a) that production is deterministic and (b) that all of the agent's wealth is invested in the cash position. Stochastic production greatly reduces optimal hedge ratios. An alternative investment greatly reduces opportunity costs of not hedging by "diluting" the cash position. Stochastic production and/or alternative investments render the costs associated with hedging relatively more important, yielding almost negligible net benefits of hedging. Hence, hedging costs typically dismiss in hedging models for being seemingly negligible are important determinants of hedging behavior.