Futures Hedging under Prospect Utility and Knightian Uncertainty
This paper introduces Knightian uncertainty and loss aversion into the hedging decision framework. Knightian uncertainty allows for imprecision in the joint density function of spot and futures prices. Loss aversion dictates that an individual is more sensitive to losses (compared to a reference point) than to gains. The optimal futures position is characterized. It is found that inertia prevails. That is, there is a wide range of parameter configurations under which the conventional one-to-one hedge strategy is optimal. Moreover, loss aversion acts to reduce any deviation from this conventional strategy.
KeywordsFuture Market Loss Aversion Future Price Future Contract Belief Function
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