Semistatic hedging and pricing American floating strike lookback options

We price an American floating strike lookback option under the Black–Scholes model with a hypothetic static hedging portfolio (HSHP) composed of nontradable European options. Our approach is more efficient than the tree methods because recalculating the option prices is much quicker. Applying put–call duality to an HSHP yields a tradable semistatic hedging portfolio (SSHP). Numerical results indicate that an SSHP has better hedging performance than a delta-hedged portfolio. Finally, we investigate the model risk for SSHP under a stochastic volatility assumption and find that the model risk is related to the correlation between asset price and volatility.     

Hedging and temporal permit issuances in cap-and-trade programs: The Market Stability Reserve under risk aversion

Cap-and-trade programs such as the European Union's Emissions Trading System (EU ETS) expose firms to considerable risks, to which the firms can respond with hedging. We develop an intertemporal stochastic equilibrium model to analyze the implications of hedging by risk-averse firms. We show that the resulting time-varying risk premium depends on the size of the permit bank. Applying the model to the EU ETS, we find that hedging can lead to a U-shaped price path, because prices initially fall due to negative risk premiums and then rise as the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thus, increases the hedging value of the permits. This offers an explanation for the recent price hike, but also implies that prices may decline in the future due to more negative risk premiums. In addition, we find higher permit cancellations through the MSR than previous analyses, which do not account for hedging.     

The Impact of Institutional Differences on Derivatives Usage: a Comparative Study of US and Dutch Firms

This paper examines the influence of institutional differences on corporate risk management practices in the USA and the Netherlands. We compare results to surveys in each country using a strategy that corrects for differences over industry and size classes across the Dutch and US samples. We document several differences in the firms’ uses and attitudes towards derivatives and attempt to attribute them to the differences in the institutional environments between the USA and the Netherlands. We find that institutional differences appear to have an important impact on risk management practices and derivatives use across US and Dutch firms.     

Hedging,Financing and Investment Decisions: A Simultaneous Equations Framework

We empirically investigate the interactions among hedging, financing, and investment decisions. We argue that the way in which hedging affects a firm's financing and investing decisions differs for firms with different growth opportunities. We find that high growth firms increase their investment, but not leverage, by hedging. However, we also find that firms with few investment opportunities use derivatives to increase their leverage.     

Designing Optimal Crop Revenue Insurance

When the indemnity schedule is contingent on the farmer's price and individual yield, an optimal crop revenue insurance contract depends only on the farmer's gross revenue. However, this design is not efficient if, as is the case with available contracts, the coverage function is based on imperfect estimators of individual yield and/or price. The producer's degree of prudence and the extent of basis risks have important influences on the optimal indemnity schedule. In this broader context, optimal protection is not provided by available U.S. crop insurance contracts and may include combinations of revenue insurance, yield insurance, futures, and options contracts.     

Hedging Housing Risk*

An unusually rich source of data on housing prices in Stockholm is used to analyze the investment implications of housing choices. This empirical analysis derives market-wide price and return series for housing investment during a 13-year period, and it also provides estimates of the individual-specific, idiosyncratic, variation in housing returns. Because the idiosyncratic component follows an autocorrelated process, the analysis of portfolio choice is dependent upon the holding period. We analyze the composition of household investment portfolios containing housing, common stocks, stocks in real estate holding companies, bonds, and t-bills. For short holding periods, the efficient portfolio contains essentially no housing. For longer periods, low-risk portfolios contain 15 to 50 percent housing. These results suggest that there are large potential gains from policies or institutions that would permit households to hedge their lumpy investments in housing. We estimate the potential value of hedges in reducing risk to households, yet yielding the same investment returns. The value is surprisingly large, especially to poorer homeowners.     

The minimum variance hedge and the bankruptcy risk of the firm

In this paper, we analyze the influence of hedging with forward contracts on the firm's probability of bankruptcy (POB). The minimization of this probability can serve as a substitute for the maximization of shareholders' wealth. It is shown that the popular minimum variance hedge is generally neither necessary nor sufficient for the minimization of the firm's POB. Moreover, our model suggests a correction of the widespread view that a reduction in the variance of the future value of the firm is inevitably accompanied by a reduction in its default risk. We derive an analytical solution for the variance-minimizing hedge ratio of a firm exposed to both input and output price uncertainty that takes into account the issue of correlation. Based on this solution, we provide a graphical analysis to prove our claim that there is a fundamental difference between hedging policies focused on bankruptcy risk and those following conventional wisdom even if positive correlation constitutes a “natural” hedge.