Risk Management with Default-Risky Forwards

Abstract

This paper studies the impact of counter-party default risk of forward contracts on a firm's production and hedging decisions. Using a model of a risk-averse competitive firm under price uncertainty, it derives several fundamental results. If expected profits from forward contracts are zero, the hedge ratio is surprisingly not affected by default risk under general preferences and general price distributions. This robustness result still holds if forwards are subject to additional basis risk. In general, the analysis shows that default risk of forward contracts is no valid reason to reduce hedge ratios. However, a firm's optimal output is negatively affected by default risk and it is generally advisable to hedge default risk with credit derivatives.

Keywords: Risk management, forwards, default risk, hedging, production

JEL Classification: G30, D81