Hedging and the Competitive Firm under Ambiguous Price and Background Risk

Abstract

This paper examines the optimal production and hedging decisions of the competitive firm that possesses smooth ambiguity preferences and faces ambiguous price and background risk. The separation theorem holds in that the firm's optimal output level depends neither on the firm's attitude towards ambiguity nor on the incident to the underlying ambiguity. We derive necessary and sufficient conditions under which the full-hedging theorem holds and thus options are not used. When these conditions are violated, we show that the firm optimally uses options for hedging purposes if ambiguity is introduced to the price and background risk by means of mean-preserving-spreads. We as such show that options play a role as a hedging instrument over and above that of futures.