How Firms Manage Risk: The Optimal Mix of Linear and Non‐linear Derivatives

Abstract

This paper provides guidance on how corporations should choose the optimal mix of "linear" and "non-linear" derivatives. Linear derivatives are products such as futures, forwards, and swaps, whose payoffs vary in linear fashion with changes in the un-derlying asset price or reference rate. Non-linear derivatives are contracts with option-like payoffs, including caps, floors, and swaptions. 2002 Morgan Stanley.

How to Hedge if the Payment Date is Uncertain

“…Second, for shorter periods and with moderate dependence, the linear optimal strategy works quite well, so it may not be necessary to always include time and price risk dependence in one's hedging policy, particularly for the USD-euro exchange rate. This latter result can help explain the findings of Gay et al (2002) and Huang et al (2007), in which a large part of surveyed firms use only linear derivatives to hedge currency exposure.…”

“…Therefore, many non-financial firms primarily use linear hedging instruments for their risk management. Gay et al (2002) report that 69% of non-financial firms in their sample use only linear derivatives to manage commodity price risk and 75% of firms rely solely on linear derivatives to hedge exchange rate risk. Similarly, Huang et al (2007) find that 73% of a group of firms that use derivatives to manage either currency or interest rate risks use linear instruments exclusively.…”

The Impact of Regulation on Corporate Hedging Activities and the Response of Corporates – A Preliminary Conceptual Framework

“…Brown and Toft (2002) modelled a profit-maximizing firm that is confronted with both price and quantity uncertainties and financial distress. Gay, Nam, and Turac (2002) and (2003) examined how corporations should choose their optimal mix of linear and non-linear derivatives with price and quantity risk.…”

Corporate hedging under a resource rent tax regime

“…Just as forward and futures contracts (swaps) have been the main vehicles for risk transferral in the Nordic electricity market since the market's inception in 1995, there is ample evidence in the literature documenting the widespread use of linear hedging strategies. In a study of U.S. nonfinancial firms, Gay, Nam, and Turac (2002) report that 69% of commodity risk exposures, 75% of currency exposures, and 70% of interest exposures are managed with linear derivatives. Huang, Ryan, and Wiggins (2007) find that 73% of firms that use derivatives manage interest and currency risk exposures entirely in terms of linear hedging instruments.…”