The Impact of Price-Induced Hedging Behavior on Commodity Market Volatility

Abstract

The utility maximization problem of a grain producer is formulated and solved numerically under prospect theory as an alternative to expected utility theory. Conventional theory posits that the optimal hedging position of a producer should not increase solely due to increases in the level of futures prices. However, a strong degree of positive correlation is apparent in the data. Our results show that with prospect theory serving as the underlying behavioral framework, the optimal hedge of a producer is affected by changes in futures price levels. AbstractThe utility maximization problem of a grain producer is formulated and solved numerically under prospect theory as an alternative to expected utility theory. Conventional theory posits that the optimal hedging position of a producer should not increase solely due to increases in the level of futures prices. However, a strong degree of positive correlation is apparent in the data. Our results show that with prospect theory serving as the underlying behavioral framework, the optimal hedge of a producer is affected by changes in futures price levels. The implications of this price-induced hedging behavior on spot prices and volatility are subsequently considered.