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Economic Modelling
journal homepage: www.elsevier.com/locate/ecmod
College of Economics and Management, Nanjing University of Aeronautics and Astronautics, Nanjing, China
Department of Economics, Hong Kong Baptist University, Hong Kong
c
Business School of Ningbo University, Ningbo, China
d
School of Mathematics and Statistics, Xi'an Jiaotong University, Xi'an, China
b
a r t i c l e
i n f o
Article history:
Accepted 8 August 2015
Available online xxxx
JEL classication:
D21
D24
D81
a b s t r a c t
In this paper, we investigate regret-averse rms' production and hedging behaviors. We rst show that the
separation theorem is still alive under regret aversion by proving that regret aversion is independent of the
level of optimal production. On the other hand, we nd that the full-hedging theorem does not always hold
under regret aversion as the regret-averse rms take hedged positions different from those of risk-averse rms
in some situations. With more regret aversion, regret-averse rms will hold smaller optimal hedging positions
in an unbiased futures market. Furthermore, contrary to the conventional expectations, we show that banning
rms from forward trading affects their production level in both directions.
2015 Published by Elsevier B.V.
Keywords:
Production
Hedging
Regret aversion
Risk aversion
Competitive rms
1. Introduction
Since the seminal work of Sandmo (1971), Holthausen (1979), Katz
and Paroush (1979) and others, there has been much theoretical and
empirical research on the economic behavior of the competitive rm
under price risk. In classical economic theory under uncertainty, two
main results are derived: the separation theorem and the full-hedging
theorem. The separation theorem documents that for risk-averse
rms, their risk attitude and the distribution of prices are independent
of their optimal production decision. On the other hand, the fullhedging theorem tells us that if the futures price is unbiased, riskaverse rms take a fully hedged position to eliminate the risk of price
The authors thank the Editor, Professor Paresh Narayan, the Associate Editor, Professor
Niklas Wagner, and two anonymous referees for their constructive comments and
suggestions, which help us clarify more precisely the results and lead to the substantial
improvement of an early manuscript. The authors are grateful to Professors Donald Lien,
Agnar Sandmo, Robert I. Webb, and Kit Pong Wong for their valuable comments, which
have signicantly improved this manuscript. The second author would like to thank
Professors Robert B. Miller and Howard E. Thompson for their continual guidance and
encouragement. This research is partially supported by the Fundamental Research Funds
for the Central Universities (NR2015001), Hong Kong Baptist University (FRG2/14-15/
106, FRG2/14-15/040), Research Grants Council of Hong Kong (Project Number
12502814), Natural Science Foundation of Zhejiang Province (LY15A010006) Grants,
Research Project of the National Statistics (2013LY119), and Ningbo University Talent
Project (ZX2014000781).
Corresponding author at: Business School of Ningbo University, China. Tel.: +86 186
0574 87600396.
E-mail address: tsunfangxu@163.com (Q. Xu).
http://dx.doi.org/10.1016/j.econmod.2015.08.007
0264-9993/ 2015 Published by Elsevier B.V.
154
with those for risk-averse competitive rms. The nal section offers
some discussions and conclusions.
2. Assumptions and the model setup
Suppose that a competitive rm produces Q units of a product at
time 0 and will sell all units at time 1. We follow Broll et al. (2006)
and others by assuming that the production cost, C(Q), is strictly convex,
such that C(0) = C(0) = 0, C() N 0 and C() N 0, to reect the rm's
~
production technology to have decreasing returns to scale. The price, P,
is random at time 1 with support on PP, such that 0 b P b P b . In addition, there is a corresponding futures contract that matures at time 1
with price P f at time 0. We also assume that the producer wants to
hedge against the risk that the price of his/her produced goods may
drop so that he/she sells X1 units of the product under the futures contract and he/she will deliver X units of the product against the futures
contract at time 1. Letting be the prot at time 1, we have
~ P~ QX P f XC Q :
2:1
2:2
Q 0
Q 0;X
Q 0;X
3:1
The expectation E() is with respect to the cumulative distribution
~
function, F(P), of the random output price P.
The rst-order conditions are then given by:
nn h i
io
h
ioh
0
~
Q 0;
E U 0 P~ g 0 max P~ P~
PC
nn h i
io
h
ioh
E U 0 P~ g 0 max P~ P~
P f P~ 0;
155
3:4
3:2
3:3
will hold automatically given that all the assumed properties of U and
g() are satised. This implies that the solutions obtained from the rstorder condition in (3.3) are indeed the optimal values.
From the Eq. in (3.3), we get:
h i
h
i
GX; Q Cov U 0 P~ ; P~ Cov g 0 max P~ P~ ; P~
nn h i
io
h
ioh
0;
P f E P~
E U 0 P~ g 0 max P~ P~
3:5
when X = X and Q = Q.
Now, we evaluate GX; Q at X = Q = Q. Notice that in this situation,
~ P f Q CQ , which is a xed value. This implies that
we have P
P f C 0 Q ;
~ P
~ 0: On the other hand,
CovU 0 P;
~
regardless of whether Pf is smaller than, equal to, or larger than EP.
h
i
dg 0 max P~ P~
dP~
i dmax P~
g max P~ P~
dP~
h
i
max ~
~
~
g
P P Q P N0:
h
3:6
The rst term on the right-hand side of (3.6) is the product of the
expected marginal utility of the regret-averse utility function V;
~ In a contango or unbiased
and the difference between Pf and EP.
market, this term cannot be positive. The second term measures the
co-movement of the uncertain price P~ and marginal effect for the
regret-averse attribute. With an increase in the output price, the ex~
~ will increase at X = Q = Q and the feeling of
post loss, max P
P,
regret for not producing more and for selling less in the futures market
would increase too. These would nally lead to the nding that the
optimal production level Q is larger than the optimal hedging position
X, even in an unbiased market.
We turn to studying the behavior of the risk-averse rm under the
same situation as stated in Proposition 3. Similarly, we set X and X to
156
h
i
Cov g 0 max P~ P~ ; P~
~
n h
io ;
P E P
E g 0 max P~ P~
f
3:7
aversion, the risk-aversion effect will play a leading role and the rm
will perform similar to a rm with only risk aversion. As a result,
~ We summarize the results in the following
X N Q when P f NEP.
proposition.
Proposition 5. Under the assumptions described in Section 2,
a. if the futures contract price Pf is larger than the transformed
~ such that P f E P,
~ or
~ E P,
expectation of P,
~
b. if the futures contract price Pf is larger than the expected price EP
with the following two conditions:
E P~ b P f b E P~
and
n h ioh
i
E U 0 P~
P f E P~
i
o ;
b n h
f
~
E g 0 max P~ P~
PP
h
i
i o
n h
Cov g 0 max P~ P~ ; P~
E g0 max P~ P~ P~
n h
io n h
io E P~ N 0:
E g 0 max P~ P~
E g 0 max P~ P~
3:8
~ and we use E P
~ to denote EHP.
~ Hence, the condifunction of HP
f
~
~
tion in (3.7) can be expressed as P E PNEP. Thus, with regret aver-
sion, different from the situation in which the managers are only risk
~ is not enough to ensure that the optimal
averse, the condition P f NEP
hedging position X is larger than the optimal production level Q.
Instead, it requires the condition Pf to be larger than a transformed
~ of P~ with respect to the regret function g().
expectation E P
3:9
3:11
3:10
from (3.9) one could easily conclude that GQ ; Q N0, and thus, X* N Q*.
Now we provide some explanations for the condition in (3.10). It is easy
f
~
~ measures the riskEP
to see that the numerator EfU 0 PgP
f
~
~ PP
~
P
g
aversion effect, while the denominator Efg 0 max P
can explain the regret-aversion effect. Thus, when the regret parameter
is bounded by the relative effect of both risk aversion and regret
f
~
~
EfU 0 PgP
EP
,
f
~
~ PP
~
P
g
Efg 0 max P
the risk-aversion effect. In this situation, the rm will regret not producing more and selling less in the futures market. This will lead to the
optimal production level Q, which is larger than the optimal hedging
position X.
It is interesting to know whether regret-averse rms will
take a higher or lower optimal hedging position when their regretaverse attribute changes. To answer this question, we study the
157
~ PQ
~ X P f X CQ . From the rst-order
Proof. Denote P
condition in (3.3), we get
From Proposition 5 and Property 6, we nd that X N Q 0 if the futures price is considerably higher than the expected price. Under this
situation, from Proposition 8, we can conclude that Q0 b Q. On the
~ we show that X b Q. Since X can be positive
other hand, if P f EP,
or negative, from Proposition 8, Q0 can be smaller or larger than Q.
f X; E
nn h i
io
h
ioh
U 0 P~ g0 max P~ P~
P f P~ 0
when X = X. Applying the implicit function theorem and the secondorder condition, we obtain
n h
io
ih
dX
f
sign E g0 max P~ P~
sign
sign
:
P f P~
d
~ and
From Proposition 3, we can obtain that X b Q when P EP,
~ P
~ b 0. On the other hand, from the rst-order conthus, CovU 0 P;
dition in (3.3), we know that
f
n h
io
ih
1 n h ih f ~ io
P f P~ E U 0 P~
P P
E g 0 max P~ P~
h i
1
Cov U 0 P~ ; P~ b 0:
bute. The above result implies that with an increase in the output
~
~
price, the ex-post loss, max P
P, will also increase at X = X and
h
ioh
nn h i
io
0
~
E U 0 0 P~ g 0 max P~ 0 P~
Q0
PC
0:
3:12
3:13
If the above term is negative (positive), then, from Eq. (3.12) and the
corresponding second-order condition, we have Q0 b (N) Q. On the
other hand, differentiating EV; max in (3.1) with respect to X
and evaluating the resulting derivative at Q = Q and X = 0 yields
A If X N (b) 0, it follows from the rst-order condition stated in (3.3)
and the corresponding second-order condition that A is positive
The result is different from that for the purely risk-averse rm.
~ A can be rewritten
To be precise, we set = 0 and P f EP,
~ CQ ; PN0,
~
as CovU 0 PQ
and thus, X N 0 and Q0 b Q.2 This is
~ the
the well-known result in Holthausen (1979). That is, if P f EP,
optimal output level for the purely risk-averse rm with hedging, Q,
must be larger than that without hedging, Q0. In other words, in an
unbiased forward market, forward hedging always promotes production
for the purely risk-averse rm. However, for the regret-averse rm, banning
the rm from forward trading may induce the rm to produce more or less,
even in an unbiased forward market. As explained above, for the regretaverse rm, even in an unbiased forward market, X b Q, and thus, X
can be negative or positive. Thereafter, we apply Proposition 8 and
obtain the result that Q0 can be smaller or larger than Q.
To see the intuition for Proposition 8, we recast Eq. (3.12) as
n h i
h
i o
Cov U 0 0 P~ g 0 max P~ 0 P~ ; P~
0
~
n h i
h
io :
C Q E P
E U 0 0 P~ g 0 max P~ 0 P~
0
This equation states that the rm's optimal output level, Q0, is the
one that equates the marginal cost of production, C(Q0), to the certainty
equivalent output price that takes both the rm's risk aversion and
regret aversion preferences into account. Indeed, the second term on
the right-hand side of the above equation captures the price risk
premium, which must be negative (positive) if the rm optimally sells
(purchases) its output forward, i.e., X N (b)0, thereby implying that
Q0 b (N)Q.
In the absence of regret aversion, i.e., 0, the risk premium of price
is unambiguously negative since U b0. In this case, X N 0, and thus,
Q0 b Q which is the well-known result of Holthausen (1979). When
regret aversion prevails, the risk premium of price could be positive or
negative. This is due to the existence of the regret function g(). With
0 ~
~
P, will
an increase in the output price, the ex-post loss, max P
increase. The co-movement of the uncertain price P~ and the marginal
0 ~
~
~ will
effect for the regret-averse attribute Covfg 0 max P
P; Pg
then be positive.
4. Conclusion and discussion
In this paper, we extend previous studies on risk-averse competitive
rms to examine the production and hedging behaviors of regret-averse
competitive rms when there is a futures market. We rst nd that
regret aversion has no effect on the optimal production decision so
that the separation theorem is still alive under regret aversion. In addition, we show that with an unbiased futures price, the regret-averse
rm will take an under-hedged position. This implies that under regret
aversion, the full-hedging theorem does not hold. We nd that with
more regret aversion, regret-averse managers will take a smaller
optimal hedging position in an unbiased futures market. Last, we compare the results using hedging with the results in which rms cannot
2
Recall that the optimal output level and hedging position for the risk-averse rm are
given by Q and X, respectively.
158
3
We would like to show our appreciation to the anonymous reviewer who point out
this problem.
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