RELAXING THE ASSUMPTIONS OF MINIMUM-VARIANCE HEDGING

The most important minimum-variance hedge-ratio assumptions are (a) th at production is deterministic and (b) that all of the agent's wealth is invested in the cash position. Stochastic production greatly reduce s optimal hedge ratios. An alternative investment greatly reduces oppo rtunity costs of not hedging by ''diluting'' the cash position. Stocha stic production and/or alternative investments render the costs associ ated with hedging relatively more important, yielding almost negligibl e net benefits of hedging. Hence, hedging costs typically dismissed in hedging models for being seemingly negligible are important determina nts of hedging behavior.