Econometric tests of firm decision making under uncertainty - optimal output and hedging: reply.

• Author: Park, Timothy A.
• Position: Response to article by Ardeshir J. Dalal in this issue, pp. 213

The expected utility model of the competitive firm under price uncertainty has yielded a rich set of implications for optimal firm decision making. Recent research has focussed on modeling the complete sources of risk influencing firms along with the alternative institutions and marketing strategies available for managing risk.

The authors of the comment on Park and Antonovitz [4] continue this line of research by incorporating an alternative assumption about the relationship between the spot and futures prices directly into the model of output and hedging decisions. Other assumptions about spot and futures prices are also reasonable and can be empirically justified but we did not pursue these assumptions in our paper.

For example, Lapan, Moschini and Hanson [3] discussed how optimal decisions are affected by the decision maker's expectations about futures prices relative to the current futures price. One reasonable assumption is that the producer's expectations of the second period futures price equals the price of the current futures contract. This assumption implies that [Mathematical Expression Omitted]. Comparative statics results can be developed for this case of unbiased expectations. As the authors demonstrate additional assumptions about the structure of the decision model will change the form of the derived output and hedging decisions and the set of testable restrictions on optimal output and hedging decisions by the firm.

The relationship between spot and futures prices has been specified in at least two different forms. Both Lapan, Moschini, and Hanson [3] and Benninga, Eldor, and Zilcha [1] write the cash price as a linear function of the futures price:

[Mathematical Expression Omitted]

where [Mathematical Expression Omitted] is independent of [Epsilon] and [Mathematical Expression Omitted]. Theoretical and empirical models to derive and estimate the optimal minimum variance hedge using ordinary least squares regressions are based on this specification relating spot and futures prices. However, this common specification is the reverse of that proposed by the authors of this comment. A non-linear relationship for basis movements is another alternative specification that could be incorporated into the model.

The direction of regressability has important implications about the relationship between spot and futures prices and does change the structure of the decision model. Consider the specification proposed by Lapan, Moschini...