OPTIMAL HEDGE RATIOS WITH RISK-NEUTRAL PRODUCERS AND NONLINEAR BORROWING COSTS

A new theory of hedging is derived assuming producers are risk neutral , forward pricing is costly, and borrowing costs are nonlinear. The st andard risk-minimizing hedge ratio is derived when forward pricing is costless. When the assumption of costless hedging is dropped, high-lev eraged firms are shown to hedge more than do low-leveraged firms. If t he value of capital is uncorrelated with output price, firms are shown to hedge more as cash price variability increases. Thus, the model ca n be consistent with what firms actually do.