A note on output hedging with cost uncertainty

Using a general framework and a multiple‐input technology, we thoroughly investigate the hedging and production decisions under cost uncertainty. In doing so, we show the impact of the cost risk on the optimal output, hedge and hedge ratio. Copyright © 2006 John Wiley & Sons, Ltd.     

The choice between multiplicative and additive production uncertainty

When modeling output uncertainty, the multiplicative specification is consistently chosen over the additive form, despite the latter being arguably intuitively more obvious. The rationale for this seems to be that when production risk is the only source of uncertainty, additive uncertainty does not reduce output below the certainty level, while multiplicative uncertainty does. We show that, in the absence of hedging, this result is drastically modified when there is simultaneous price and output uncertainty. In this situation the theoretical implications of the two specifications are sufficiently similar to preclude any a priori choice between the two. Thus the choice between the additive and multiplicative formulations may be dictated by how each performs in empirical analyses.     

Hedging decisions with price and output uncertainty

We generally show that the introduction of output uncertainty does not affect the hedging position of the firm.