Risk Management with Default-Risky Forwards

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Abstract

To study the impact of counter-party default risk of forward contracts on a firm’s production and hedging decisions, I use a model of a risk-averse competitive firm under price uncertainty. I find that if expected profits from forward contracts are zero, the hedge ratio is not affected by default risk under general preferences and general price distributions. My analysis shows that if the size of a firm’s forward position does not affect the counter-party’s default probability, default risk is no reason to reduce hedge ratios. However, a firm’s optimal output is negatively affected by default risk, and it is generally advisable to hedge default risk with credit derivatives.