Optimal Corporate Hedging Using Options with Basis and Production Risk

In this paper we investigate the optimal hedging strategy for a firm using option contracts, where both the role of production (quantity) and basis (proxy) risk are considered. Contrary to the existing literature, we find that the exercise price which minimizes the shortfall of the hedged portfolio is primarily affected by the amount of cash spent on the hedging program. Also, we decompose the effect of quantity and proxy risk showing that the latter greatly affects hedging effectiveness while the former drives the choice of the optimal option contract. Finally, fitting the model parameters to match a financial turmoil scenario confirms that choosing a suboptimal option moneyness leads to a non-negligible economic loss