Original Article
How Firms Should Hedge

Authors: Brown G.W.; Toft K.B.

Source: Review of Financial Studies, Volume 15, Number 4, 2002 , pp. 1283-1324(42)

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Abstract:

Substantial academic research explains why firms should hedge, but little work has addressed how firms should hedge. We assume that firms can experience 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 facing both hedgable (price) and unhedgable (quantity) risks. 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. Finally, we discuss how our model may be applied in practice.

Document Type: Original article

Affiliations: University of North Carolina Goldman Sachs International

Publication date: 2002-01-01

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The Review of Financial Studies is a major forum for the promotion and wide dissemination of significant new research in financial economics. As reflected by its broadly based editorial board, the Review balances theoretical and empirical contributions. The primary criteria for publishing a paper are its quality and importance to the field of finance, without undue regard to its technical difficulty. Finance is interpreted broadly to include the interface between finance and economics. The Review is sponsored by The Society for Financial Studies. The editors of the Review and officers of the Society are elected for limited terms.