Hedging price risk when real wealth matters

This paper analyzes optimal hedging of a tradable risk (e.g. price risk or exchange rate risk) with forward contracts in the presence of untradable in flation risk. Utility is defined over real wealth. Optimal forward position s are derived relative to a given initial exposure in the tradable risk. A nominally unbiased forward market usually implies a non-zero real risk prem ium and hence some risk taking. If untradable inflation risk is a monotone function of the tradable risk plus noise, cross hedging and speculating on the real risk premium are conflicting objectives; the level of relative ris k aversion determines which objective is dominant in a nominally unbiased f orward market. (C) 2000 Elsevier Science Ltd. All rights reserved. JEL clas sification: D81; G11; D11.