A Theoretical Explanation of the Firm's Hedging Policy

The paper develope a models for evaluating the optimal hedging and trading strategies under default risk mitigation policies. It deals with an exchange traded derivative Instrument, i.e. future contracts but ures can succeed in locking the asset value, but they may create two additional risks such as default and liquidity risk. Default risk can be mitigated via collateralization, i.e. the margin account. This type of collateral is highly formalized (from the clearing house) and it does not depend on counterparty, credit quality. The liquidity risk may arise from the inability to fund a hedging strategy (to top up the margin account to the initial margin in case of a margin call), due to borrowing constraints. A rational investor knows that a hedging strategy comes with a borrowing strategy. We are interested in the implication, of the marking to market mechanism that characterize futures in presence of endogenous borrowing conetraints. Therefore we characterize the optimal hedge in a dynamic framework by providing analytical solutions. We show that the magnitude of hedging of an investor facing borrowing constraint is always lower than the one of an unconstrained Investor. The model captures the empirically observed fact, reported in Brown et al. (2003), that the hedge magnitude increases when the prices that need to be hedged move in their favor and decrease when prices moves against them. Third, the model also predict, that the hedge increases as the volatility of the underlying exposure increase. Other results follow.