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Rev Fin 2002; 15:1283-1324
© 2002 the Society for Financial Studies

How Firms Should Hedge

Gregory W. Brown
University of North Carolina

Klaus Bjerre Toft
Goldman Sachs International

Address correspondence to Gregory W. Brown, Department of Finance, Kenan-Flagler School of Business, University of North Carolina at Chapel Hill, Campus Box 3490, McColl Building, Chapel Hill, NC 27599-3490, or e-mail: gregwbrown{at}unc.edu.

Abstract

Substantial academic research explains why firms should hedge, but little work has addressed how firms should hedge. We assume that firms can experience costly states of nature and derive optimal hedging strategies using vanilla derivatives (e.g., forwards and options) and custom "exotic" derivative contracts for a value-maximizing firm facing both hedgable (price) and unhedgable (quantity) risks. Customized exotic derivatives are typically better than vanilla contracts when correlations between prices and quantities are large in magnitude and when quantity risks are substantially greater than price risks. Finally, we discuss how our model may be applied in practice.


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