The variance-minimizing hedge with put options

Bell, Peter N (2014): The variance-minimizing hedge with put options.

Abstract

Certain commodity producers face uncertain output and price, but can trade financial derivatives on price. I consider how best to use a put option on price. I introduce the variance surface, which is a data visualization technique that shows the level of variance across a grid of values for the two choice variables, quantity of options and strike price. The variance-minimizing hedge has strike deep in the money and optimal quantity close to expected output, but the variance surface shows there are near-best choices that are less expensive.

• Item Type: MPRA Paper
• Language: English
• Keywords: Variance-minimizing hedge, put option, simulation, data visualization.
• Subjects: C - Mathematical and Quantitative Methods > C0 - General > C00 - General; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling; G - Financial Economics > G2 - Financial Institutions and Services > G22 - Insurance ; Insurance Companies ; Actuarial Studies; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q1 - Agriculture > Q14 - Agricultural Finance

References

Adam, T.R. (2002). Risk Management and the Credit Risk Premium. Journal of Banking and Finance, 26(2-3), 243—269.

Brown, G.W., & Toft, K.B. (2002). How Firms Should Hedge. The Review of Financial Studies, 15(4), 1283—1324.

Feder, G. Just, R.E., & Schmitz, A. (1980). Futures Markets and the Theory of the Firm Under Price Uncertainty. The Quarterly Journal of Economics, 94(2), 317—328.

Lapan, H., & Moschini, G. (1994). Futures hedging under price, basis, and production risk. American Journal of Agricultural Economics, 76, 465—477.

Lemieux, V. (Ed.). (2013). Financial Analysis and Risk Management: Data Governance, Analytics and Life Cycle Management. Berlin, Heidelberg: Springer-Verlag.

Losq, E. (1982). Hedging with price and output uncertainty. Economics Letters, 10, 65—70.

McKinnon, R.I. (1967). Futures Markets, Buffer Stocks, and Income Stability for Primary Producers. Journal of Political Economy, 75(6), 844—861.

Oum, Y., & Oren, S.S. (2010). Optimal Static Hedging of Volumetric Risk in a Competitive Wholesale Electricity Market. Decision Analysis, 7(1), 107—122.

Rolfo, J. (1980). Optimal Hedging under Price and Quantity Uncertainty: the Case of a Cocoa producer. Journal of Political Economy, 88, 110—116.