Economic Modelling 51 (2015) 153158

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Economic Modelling
journal homepage: www.elsevier.com/locate/ecmod

Production and hedging decisions under regret aversion

Xu Guo a, Wing-Keung Wong b, Qunfang Xu c,, Xuehu Zhu d
a

College of Economics and Management, Nanjing University of Aeronautics and Astronautics, Nanjing, China
Department of Economics, Hong Kong Baptist University, Hong Kong
c
Business School of Ningbo University, Ningbo, China
d
School of Mathematics and Statistics, Xi'an Jiaotong University, Xi'an, China
b

a r t i c l e

i n f o

Article history:
Accepted 8 August 2015
Available online xxxx
JEL classication:
D21
D24
D81

a b s t r a c t
In this paper, we investigate regret-averse rms' production and hedging behaviors. We rst show that the
separation theorem is still alive under regret aversion by proving that regret aversion is independent of the
level of optimal production. On the other hand, we nd that the full-hedging theorem does not always hold
under regret aversion as the regret-averse rms take hedged positions different from those of risk-averse rms
in some situations. With more regret aversion, regret-averse rms will hold smaller optimal hedging positions
in an unbiased futures market. Furthermore, contrary to the conventional expectations, we show that banning
rms from forward trading affects their production level in both directions.
2015 Published by Elsevier B.V.

Keywords:
Production
Hedging
Regret aversion
Risk aversion
Competitive rms

1. Introduction
Since the seminal work of Sandmo (1971), Holthausen (1979), Katz
and Paroush (1979) and others, there has been much theoretical and
empirical research on the economic behavior of the competitive rm
under price risk. In classical economic theory under uncertainty, two
main results are derived: the separation theorem and the full-hedging
theorem. The separation theorem documents that for risk-averse
rms, their risk attitude and the distribution of prices are independent
of their optimal production decision. On the other hand, the fullhedging theorem tells us that if the futures price is unbiased, riskaverse rms take a fully hedged position to eliminate the risk of price
The authors thank the Editor, Professor Paresh Narayan, the Associate Editor, Professor
Niklas Wagner, and two anonymous referees for their constructive comments and
suggestions, which help us clarify more precisely the results and lead to the substantial
improvement of an early manuscript. The authors are grateful to Professors Donald Lien,
Agnar Sandmo, Robert I. Webb, and Kit Pong Wong for their valuable comments, which
have signicantly improved this manuscript. The second author would like to thank
Professors Robert B. Miller and Howard E. Thompson for their continual guidance and
encouragement. This research is partially supported by the Fundamental Research Funds
for the Central Universities (NR2015001), Hong Kong Baptist University (FRG2/14-15/
106, FRG2/14-15/040), Research Grants Council of Hong Kong (Project Number
12502814), Natural Science Foundation of Zhejiang Province (LY15A010006) Grants,
Research Project of the National Statistics (2013LY119), and Ningbo University Talent
Project (ZX2014000781).
Corresponding author at: Business School of Ningbo University, China. Tel.: +86 186
0574 87600396.
E-mail address: tsunfangxu@163.com (Q. Xu).

http://dx.doi.org/10.1016/j.econmod.2015.08.007
0264-9993/ 2015 Published by Elsevier B.V.

uncertainty. For reference, see Broll and Zilcha (1992), Adam-Mller

(1997), Broll and Eckwert (1998, 2000), and Lien (2000).
In this paper, we extend the theory by examining the production and
hedging behavior of a competitive rm under the premise that the rm
demonstrates both risk-averse behavior and regret-averse attitude. In
recent years, there has been a growing literature on rm behavior that
assumes not only risk aversion but also regret aversion. For example,
if rms' prices turn out to be very high and sales turn out to be very
good, rms might regret not producing more. Conversely, if prices
turn out to be low and sales are poor, rms might regret overproducing. Savage (1951) is the rst to propose that decision makers
include regret in their decision-making processes. Bell (1982),
Fishburn (1982), and Loomes and Sugden (1982, 1987) develop a
formal analysis of regret theory, which is later extended by Sugden
(1993) and Quiggin (1994). Following the pioneering work of Sandmo
(1971) on the optimal output of a risk-averse rm under price uncertainty, Paroush and Venezia (1979) rst assume that competitive
rms have a regret-averse utility. Nonetheless, Braun and Muermann
(2004) propose using a more specic regret-averse utility function
that is easily managed. Egozcue and Wong (2012) and Wong (2014)
are the rst to study the behavior of a competitive rm when price is
unknown with the regret-averse utility introduced by Braun and
Muermann. Niu et al. (2014) further examine the production decision
of a competitive rm with a regret-averse utility. Broll et al. (2015)
study the behavior of a regret-averse rm when the exchange rate is
uncertain. There are other applications of regret aversion, for example,

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X. Guo et al. / Economic Modelling 51 (2015) 153158

the demand for insurance (Wong, 2012), portfolio investment (Barberis

et al., 2006; Muermann et al., 2006), auctions (Engelbrecht-Wiggans
and Katok, 2008; Feliz-Ozbay and Ozbay, 2007), newsvendor model
(Perakis and Roels, 2008), and banking issues (Tsai, 2012). To apply
the regret theory to nance, Wagner (2002) derives a Markowitz-type
model of portfolio choice with variable regret aversion. Readers may
refer to Bleichrodt and Wakker (2015) for a comprehensive review of
the development of the regret theory.
As discussed above, some authors extend the production theory of
the risk-averse rm to that of the regret-averse rm to investigate the
optimal production decision without considering the presence of a
futures market. On the other hand, some authors study the production
and hedging behaviors of the risk-averse rm. In addition, Michenaud
and Solnik (2008) apply regret theory to get solutions to optimal
currency hedging choices. As far as we know, there is no previous
work that studies the production and hedging behaviors of the regretaverse rm. Nonetheless, it is of great interest to study the effect of
regret aversion on the optimal production and hedging decisions
when a futures market exists. For example, it would be interesting to
know whether the two notable resultsthe separation and fullhedging theoremsare still valid if rms are regret averse. Our paper
provides a natural extension of Wong (2014) by adding the opportunity
for regret-averse rms to trade in futures contracts. This is in the same
spirit as Holthausen (1979), who adds this opportunity to Sandmo
(1971) for risk-averse rms.
We rst examine whether the separation theorem still holds for the
regret-averse rm. It is well known (Niu, et al., 2014; Wong, 2014) that
under certain sufcient conditions and without hedging, the optimal
output level is smaller under uncertainty than under certainty. When
a futures market exists, we nd that regret aversion has no effect on
the optimal production decision. To be precise, optimal output levels
are the same for both risk-averse and regret-averse rms that will
choose their optimal outputs when their marginal costs are equal to
the futures price. These results imply that the separation theorem is
still alive under regret aversion.
Thereafter, we examine the full-hedging theorem for the regretaverse rm. We nd that sometimes both regret-averse and riskaverse competitive rms behave similarly, but, in other situations,
they behave differently. For example, when the futures price is smaller
than the expected price (contango market), both risk-averse and
regret-averse rms will take under-hedged positions. When the expected price and the futures price are the same (unbiased futures market),
the risk-averse competitive rm will take a fully hedged position,
while the regret-averse competitive rm will still take an underhedged position. Furthermore, when the futures price is slightly higher
than the expected price (backwardation futures market), risk-averse
rms will take an over-hedged position, but regret-averse rms
could take an under-hedged, a fully hedged, or an over-hedged
position, depending on the degree of regret aversion. These results
imply that under regret aversion, the full-hedging theorem does not
hold.
We conduct a comparative statics analysis and nd that with
more regret aversion, the optimal hedging position will become smaller
in an unbiased futures market. Moreover, we nd that the regret-averse
rm optimally produces more or less in the absence than in the
presence of a futures market. This result is different from the traditional
wisdom that forward hedging always promotes production. The theory
developed in our paper is not only useful for rms in managing their
production levels and hedging positions, but it also aids rms' competitors, business partners, shareholders, and stock and bond investors in
their investment decisions as well as assisting policy makers in their
policy setting processes.
In Section 2, we state the assumptions and the model setup for a
competitive rm that is not only risk averse but also regret averse. In
Section 3, we derive the theory to describe the production and hedging
behaviors for regret-averse competitive rms and compare the results

with those for risk-averse competitive rms. The nal section offers
some discussions and conclusions.
2. Assumptions and the model setup
Suppose that a competitive rm produces Q units of a product at
time 0 and will sell all units at time 1. We follow Broll et al. (2006)
and others by assuming that the production cost, C(Q), is strictly convex,
such that C(0) = C(0) = 0, C() N 0 and C() N 0, to reect the rm's
~
production technology to have decreasing returns to scale. The price, P,
is random at time 1 with support on PP, such that 0 b P b P b . In addition, there is a corresponding futures contract that matures at time 1
with price P f at time 0. We also assume that the producer wants to
hedge against the risk that the price of his/her produced goods may
drop so that he/she sells X1 units of the product under the futures contract and he/she will deliver X units of the product against the futures
contract at time 1. Letting be the prot at time 1, we have
~ P~ QX P f XC Q :

2:1

To address the notion of regret, we follow Braun and Muermann

(2004) and others by employing the following bivariate (two-attribute)
regret-averse utility function V to get the ex-post suboptimal decision:
V ; max U g max ;

2:2

in which the rst term is the von NeumannMorgenstern utility

function U to reect risk aversion satisfying U 0 N 0 and U b 0. The
second term takes care of the rm's regret prospect. The regret function
g() indicates the regret-averse attribute in which g(0) = 0, g() N 0,
and g() N 0. The parameter 0 is the weight of the regret attribute
or regret coefcient measuring the extent of regret aversion. max is
the ex-post optimal prot that the rm could have earned if there
were no price uncertainty.
In our framework, when the realized output price P is observed, X
will be zero since there is no uncertainty. The optimal Q is calculated
by maximizing the following function
max U max U fPQC Q g
Q 0

Q 0

and getting C(Q) = P. When the value of P changes, the optimal Q

changes accordingly. Thus, max(P) appears in the form of PQ(P)
C[Q(P)] with C[Q(P)] = P. For example, if the value of the uncertain
price P~ is realized to be P1, the manager will make production and hedging decisions based on P1. In other words, the manager will make the
optimal decision based on the realized product price. However, in
practice the price is unknown and random. Thus, the max is also random
~
and depends on every possible value of the price P.
In order to compare the difference between regret-averse and riskaverse rms, in this paper we also investigate production and hedging
decisions when the competitive rm is risk averse. To get a risk-averse
utility function, one could simply set = 0 in (2.2).
3. The theory
We will use the term proposition to state new results obtained
in this paper and property to state some well-known results or the
inference drawn from the propositions obtained in this paper.
1
We note that the hedging position X in our paper is different from the hedge ratio,
which is set to be between 0 and 1, while X can be negative as well as greater than one.
Readers may refer to Michenaud and Solnik (2008) for more discussion on the hedge ratio.
We would like to show our appreciation to the anonymous reviewer who point out this
problem.

X. Guo et al. / Economic Modelling 51 (2015) 153158

To obtain the optimal production and hedging for the regret-averse

competitive rm, we maximize the expectation of V in (2.2) such that:
h 
i
n h  i
h
 
 io
max E V ; max max E U P~ g max P~ P~
:

Q 0;X

Q 0;X

3:1
The expectation E() is with respect to the cumulative distribution

~
function, F(P), of the random output price P.
The rst-order conditions are then given by:

nn h  i
io
h
 
 ioh
0
~
Q  0;
E U 0  P~ g 0 max P~  P~
PC
nn h  i
io
h
 
 ioh
E U 0  P~ g 0 max P~  P~
P f P~ 0;

155

marginal cost, C(Q*), of producing that unit, thereby yielding the

optimality condition, C 0 Q  P f .
In the following, we study the properties of the optimal hedging
position. It is well-known that Pf could be smaller than, equal to, or
~ (Hirshleifer, 1988). We rst study the situation for P f
greater than EP

~ To do so, we only need to consider the rst-order condition in

EP.
(3.3).
We note that the following second-order condition:
n h  i
i2 
h
 
 ioh
b0
P f P~
E U  P~ g 00 max P~  P~

3:4

3:2
3:3

where an asterisk () indicates an optimal level.

Summing up Eqs. in (3.2) and (3.3), we get P f = C ' (Q*). Thus, we
nd that the optimal output decision is solely determined by the cost
function and the forward price as stated in the following proposition:
Proposition 1. Under the assumptions described in Section 2, the optimal
production decision is independent of the regret aversion and the optimal
output level, Q*, of the regret-averse rm is the unique solution obtained
from the following equation:

will hold automatically given that all the assumed properties of U and
g() are satised. This implies that the solutions obtained from the rstorder condition in (3.3) are indeed the optimal values.
From the Eq. in (3.3), we get:
 h  i 
 h
 
 i 
GX; Q Cov U 0 P~ ; P~ Cov g 0 max P~ P~ ; P~
nn h  i
 io
h
 
 ioh
0;
P f E P~
E U 0 P~ g 0 max P~ P~
3:5
when X = X and Q = Q.
Now, we evaluate GX; Q at X = Q = Q. Notice that in this situation,
~ P f Q  CQ  , which is a xed value. This implies that
we have P

P f C 0 Q  ;

~ P
~ 0: On the other hand,
CovU 0 P;

~
regardless of whether Pf is smaller than, equal to, or larger than EP.

h
 
 i
dg 0 max P~ P~

From Proposition 1, one could nd that the risk-averse rm obtains

its optimal output level by setting = 0 in (2.2). We state this wellknown result in the following property:
Property 2. Under the assumptions described in Section 2, the optimal
output level, Q, of the risk-averse rm is the unique solution obtained
from the following equation:
P f C 0 Q  ;
~
regardless of whether P is smaller than, equal to, or larger than EP.
f

In this paper, we set Q  and Q to be the optimal output levels of

the regret-averse and the risk-averse rms, respectively. We note
that the difference between Proposition 1 and Property 2 is that the
former states the result for regret-averse rms, while the latter states
the result for risk-averse rms. From Proposition 1 and Property 2, it
is clear that Q is always equal to Q, and thus, we conclude that
regret aversion has no effect on the optimal production decision, so that
the optimal output levels are the same for both risk-averse and regretaverse rms.
It is well-known (Egozcue and Wong, 2012) that when a risk-averse
rm faces the certain price P, it will choose an optimal output Q, such
that its marginal revenue (=P) equals its marginal cost C(Q). However, Wong (2014) and Niu, et al. (2014) have shown that a sufcient condition is needed to obtain the traditional result in which the optimal
output level will be smaller under uncertainty than under certainty
when there is no hedging.
From Proposition 1 and Property 2, we conclude that when a futures
market exists, the presence of hedging can eliminate the effect of regret
aversion on the optimal production level, so that it is similar to the certainty
case in which the price P is known, and in this situation, P f serves as the
known price P. This situation holds for risk-averse rms also.
The intuition of Proposition 1 is as follows: Given that there exists a
~ to be the
futures market, the rm can set the random output price, P,
predetermined futures price, P f. At the optimum, the rm must equate
the known marginal revenue, P f, from selling the last unit to the

dP~

 
 
 i dmax P~
g max P~ P~
dP~
h
 
 i  

max ~
~
~
g
P P Q P N0:
h

As a result, we can conclude that

 h
 
 i 
Cov g 0 max P~ P~ ; P~ N0:
~ Recall that
The above result implies that GQ  ; Q  b 0 when P f EP.


GX ; Q 0, and from the second-order condition, we can conclude
~ We summarize the nding in the following
that X b Q when P f EP.
proposition:
~ the regret-averse rm's optimal hedging
Proposition 3. When P f E P,
position, X , will be smaller than the rm's optimal output level, Q , in the
presence of regret aversion.
To explore the intuition for Proposition 3, we look into the following
equation by setting X = Q = Q in GX; Q from (3.5) and it becomes
 i
n h  i
h
 
 ioh
GQ  ; Q  E U 0 P~ g 0 max P~ P~
P f E P~
 h
 
 i 
Cov g 0 max P~ P~ ; P~ :

3:6

The rst term on the right-hand side of (3.6) is the product of the
expected marginal utility of the regret-averse utility function V; 
~ In a contango or unbiased
and the difference between Pf and EP.
market, this term cannot be positive. The second term measures the
co-movement of the uncertain price P~ and marginal effect for the
regret-averse attribute. With an increase in the output price, the ex~
~ will increase at X = Q = Q and the feeling of
post loss, max P
P,
regret for not producing more and for selling less in the futures market
would increase too. These would nally lead to the nding that the
optimal production level Q is larger than the optimal hedging position
X, even in an unbiased market.
We turn to studying the behavior of the risk-averse rm under the
same situation as stated in Proposition 3. Similarly, we set X and X to

156

X. Guo et al. / Economic Modelling 51 (2015) 153158

be the optimal hedging positions for the regret-averse and risk-averse

rms, respectively. We rst state the following well-known property
of the optimal hedging position for risk-averse rms (Holthausen,
1979) for comparison:
Property 4. The risk-averse rm's optimal hedging position, X will be
smaller than, equal to, or larger than the rm's optimal output level Q
~ respectively.
when Pf is smaller than, equal to, or larger than EP,
~ From
In the following, we consider the situation with P f NEP.
Eq. (3.6) to get GQ  ; Q  to be positive, there are two situations: rst,
f
0 max ~
~
~
~
PgP
EPCovg
P
considering the term Efg0 max P
~ P.
~ When
P;

 h
 
 i 
  Cov g 0 max P~ P~ ; P~
~
n h
 
 io ;
P E P
E g 0 max P~ P~
f

3:7

aversion, the risk-aversion effect will play a leading role and the rm
will perform similar to a rm with only risk aversion. As a result,
~ We summarize the results in the following
X N Q when P f NEP.
proposition.
Proposition 5. Under the assumptions described in Section 2,
a. if the futures contract price Pf is larger than the transformed
~ such that P f E P,
~ or
~ E P,
expectation of P,
~
b. if the futures contract price Pf is larger than the expected price EP
with the following two conditions:
 
 
E P~ b P f b E P~
and

GQ  ; Q  will be positive, which, in turn, implies that X N Q. In

addition, we get

n h  ioh
 i
E U 0 P~
P f E P~
 
 i
o ;
b n h
f
~
E g 0 max P~ P~
PP

 h
 
 i 
 
 i o
n h
 
Cov g 0 max P~ P~ ; P~
E g0 max P~ P~ P~
n h
 
 io n h
 
 io E P~ N 0:
E g 0 max P~ P~
E g 0 max P~ P~

then the regret-averse rm's optimal hedging position, X, will be

larger than the rm's optimal output level, Q, in the presence of
regret aversion.
For the optimal hedging decision, we summarize the ndings from
Propositions 3 and 5 and Property 4 in the following property:

We dene the following function:

h
 
 i
 
p
g max P~ P~
n h
 
 io dF P~
p
~ P~
P E g 0 max P
Z

Property 6. Under the assumptions described in Section 2,

3:8

for all pPP. Since (p) N 0, P 0, and P 1, there is an

~ is a cumulative distribution
increasing function, H, of P~ such that P

~ and we use E P
~ to denote EHP.
~ Hence, the condifunction of HP
f
~
~
tion in (3.7) can be expressed as P E PNEP. Thus, with regret aver-

sion, different from the situation in which the managers are only risk
~ is not enough to ensure that the optimal
averse, the condition P f NEP
hedging position X is larger than the optimal production level Q.
Instead, it requires the condition Pf to be larger than a transformed
~ of P~ with respect to the regret function g().
expectation E P

~ the regret parameter

On the other hand, if Pf is not larger than E P,
is required to be small enough to ensure that the rm's optimal
hedging position is larger than the rm's optimal output level. To
achieve this, we rewrite GQ  ; Q  in (3.6) to be:
n h  ioh
 i
P f E P~
GQ  ; Q  E U 0 P~
n h
o
 
 i
E g 0 max P~ P~
P f P~ :

3:9

If is small enough such that

n h  ioh
 i
E U 0 P~
P f E P~
o ;
 
 i
b n h
f
~
E g 0 max P~ P~
PP

3:11

3:10

from (3.9) one could easily conclude that GQ  ; Q  N0, and thus, X* N Q*.
Now we provide some explanations for the condition in (3.10). It is easy
f
~
~ measures the riskEP
to see that the numerator EfU 0 PgP

f
~
~ PP
~
P
g
aversion effect, while the denominator Efg 0 max P
can explain the regret-aversion effect. Thus, when the regret parameter
is bounded by the relative effect of both risk aversion and regret

~ both regret-averse and risk-averse competitive rms

a. when P f b EP,
will take an under-hedged position;
~ , risk-averse competitive rms will take a fully
b. when P f EP
hedged position, while regret-averse competitive rms will still
take an under-hedged position;
~ risk-averse competitive rms will take
~ b P f b E P,
c. when EP
an over-hedged position but regret-averse rms may take either
an under-hedged, fully hedged, or over-hedged position,
depending on the size of the regret coefcient (see condition
(3.11); and
~ both regret-averse and risk-averse
~ with P f E P,
d. when EP
competitive rms will take an over-hedged position.
From Property 6, it is clear that different from the purely risk-averse
rm, the optimal hedging position X is still less than the optimal
production level Q under regret aversion in an unbiased market.
Thus, the full-hedging theorem fails under regret aversion. As explained
above, regret aversion plays an important role. Another important
nding in our paper is that different from the risk-averse rm, the
regret-averse rm may still take an under-hedged position in the
~ is not
backwardation futures market. Due to regret aversion, P f NEP
sufcient enough to ensure that X N Q. Instead, it requires either
~ in the
the condition that the futures price P f is bigger than EHP
~ or the condition that the regret coefcient
sense that P f E P
is bounded from above. Under either condition, the risk-aversion
effect prevails, and thus, X N Q . However, if P f is slightly higher
~ and is large enough
~ in the sense that EP
~ b P f b E P
than EP
with N

f
~
~
EfU 0 PgP
EP
,
f
~
~ PP
~
P
g
Efg 0 max P

the regret-aversion effect will dominate

the risk-aversion effect. In this situation, the rm will regret not producing more and selling less in the futures market. This will lead to the
optimal production level Q, which is larger than the optimal hedging
position X.
It is interesting to know whether regret-averse rms will
take a higher or lower optimal hedging position when their regretaverse attribute changes. To answer this question, we study the

X. Guo et al. / Economic Modelling 51 (2015) 153158

157

comparative statics of the optimal hedging position when the regret

coefcient varies as shown in the following proposition:

(negative), and thus, the term (3.13) is negative (positive) and Q0 b

(N) Q. We summarize the result in the following proposition:

Proposition 7. The regret-averse rm's optimal hedging position, X ,

~ then X will surely decrease with an
satises the following if P f EP,
increase in the regret coefcient .

Proposition 8. If regret-averse rm's optimal hedging position X N (b) 0,

banning the rm from forward trading will lead the rm to get a lower
(higher) optimal output level, i.e., Q0 b (N) Q.

~ PQ
~  X  P f X  CQ  . From the rst-order
Proof. Denote  P
condition in (3.3), we get

From Proposition 5 and Property 6, we nd that X N Q 0 if the futures price is considerably higher than the expected price. Under this
situation, from Proposition 8, we can conclude that Q0 b Q. On the
~ we show that X b Q. Since X can be positive
other hand, if P f EP,
or negative, from Proposition 8, Q0 can be smaller or larger than Q.

f X; E

nn h  i
io
h
 
 ioh
U 0  P~ g0 max P~  P~
P f P~ 0

when X = X. Applying the implicit function theorem and the secondorder condition, we obtain
 
 
 n h
io
 
 ih
dX
f
sign E g0 max P~  P~
sign
sign
:
P f P~
d

~ and
From Proposition 3, we can obtain that X b Q when P EP,
~ P
~ b 0. On the other hand, from the rst-order conthus, CovU 0  P;
dition in (3.3), we know that
f

n h
io
 
 ih
1 n h  ih f ~ io
P f P~ E U 0  P~
P P
E g 0 max P~  P~

 h  i 
1
Cov U 0  P~ ; P~ b 0:

Thereafter, Proposition 7 holds.

We give some explanations for Proposition 7 here. From the proof,
we know that
 
 n h
io
 
 ih
dX
sign
sign E g 0 max P~  P~
P f P~
d

 h
 
 i 
sign Cov g 0 max P~  P~ ; P~ b 0:
 ~
~
~ measures the co-movement
We note that Covg 0 max P
P; P
~
of the uncertain price P and marginal effect for the regret-averse attri-

bute. The above result implies that with an increase in the output
 ~
~
price, the ex-post loss, max P
P, will also increase at X = X and

Q = Q . The feeling of regret for not selling less in futures market

would increase too. In addition, when increases, rms will become
more regret averse. This will eventually lead to a decrease in the optimal
hedging position X.
Last, we compare the results using hedging with the results in which
rms cannot hedge; for example, there is no futures market so that
rms cannot hedge (Niu et al., 2014; Wong, 2014). That is, X 0 in
(2.1). Under this situation, we denote the corresponding prot
~
and optimal output level to be 0 and Q0, respectively, such that 0 P
~ 0 CQ 0 . The corresponding rst-order condition then becomes
PQ

h
 
 ioh
nn h  i
 io
0
~
E U 0 0 P~ g 0 max P~ 0 P~
Q0
PC
0:

3:12

Differentiating EV; max  in (3.1) with respect to Q and

evaluating the resulting derivative at Q = Q and X = 0 yields
nn h
i
h
ioh
io
  
0
~  C Q  g0 max P~ PQ
~  C Q 
~
Q  :
A : E U 0 PQ
PC

3:13
If the above term is negative (positive), then, from Eq. (3.12) and the
corresponding second-order condition, we have Q0 b (N) Q. On the
other hand, differentiating EV; max  in (3.1) with respect to X
and evaluating the resulting derivative at Q = Q and X = 0 yields
A If X N (b) 0, it follows from the rst-order condition stated in (3.3)
and the corresponding second-order condition that A is positive

The result is different from that for the purely risk-averse rm.
~ A can be rewritten
To be precise, we set = 0 and P f EP,
~  CQ  ; PN0,
~
as CovU 0 PQ
and thus, X N 0 and Q0 b Q.2 This is
~ the
the well-known result in Holthausen (1979). That is, if P f EP,
optimal output level for the purely risk-averse rm with hedging, Q,
must be larger than that without hedging, Q0. In other words, in an
unbiased forward market, forward hedging always promotes production
for the purely risk-averse rm. However, for the regret-averse rm, banning
the rm from forward trading may induce the rm to produce more or less,
even in an unbiased forward market. As explained above, for the regretaverse rm, even in an unbiased forward market, X b Q, and thus, X
can be negative or positive. Thereafter, we apply Proposition 8 and
obtain the result that Q0 can be smaller or larger than Q.
To see the intuition for Proposition 8, we recast Eq. (3.12) as
n h  i
h
 
 i o
 
  Cov U 0 0 P~ g 0 max P~ 0 P~ ; P~
0
~
n h  i
h
 
 io :
C Q E P
E U 0 0 P~ g 0 max P~ 0 P~
0

This equation states that the rm's optimal output level, Q0, is the
one that equates the marginal cost of production, C(Q0), to the certainty
equivalent output price that takes both the rm's risk aversion and
regret aversion preferences into account. Indeed, the second term on
the right-hand side of the above equation captures the price risk
premium, which must be negative (positive) if the rm optimally sells
(purchases) its output forward, i.e., X N (b)0, thereby implying that
Q0 b (N)Q.
In the absence of regret aversion, i.e., 0, the risk premium of price
is unambiguously negative since U b0. In this case, X N 0, and thus,
Q0 b Q which is the well-known result of Holthausen (1979). When
regret aversion prevails, the risk premium of price could be positive or
negative. This is due to the existence of the regret function g(). With
0 ~
~
P, will
an increase in the output price, the ex-post loss, max P
increase. The co-movement of the uncertain price P~ and the marginal
0 ~
~
~ will
effect for the regret-averse attribute Covfg 0 max P
P; Pg

then be positive.
4. Conclusion and discussion
In this paper, we extend previous studies on risk-averse competitive
rms to examine the production and hedging behaviors of regret-averse
competitive rms when there is a futures market. We rst nd that
regret aversion has no effect on the optimal production decision so
that the separation theorem is still alive under regret aversion. In addition, we show that with an unbiased futures price, the regret-averse
rm will take an under-hedged position. This implies that under regret
aversion, the full-hedging theorem does not hold. We nd that with
more regret aversion, regret-averse managers will take a smaller
optimal hedging position in an unbiased futures market. Last, we compare the results using hedging with the results in which rms cannot
2
Recall that the optimal output level and hedging position for the risk-averse rm are
given by Q and X, respectively.

158

X. Guo et al. / Economic Modelling 51 (2015) 153158

hedge. We nd that when regret-averse rms take a positive (negative)

optimal hedging position, banning the rm from forward trading will
lead the rm to produce a lower (higher) optimal output level. This
result is different from the traditional wisdom that forward hedging
always promotes production.
In this paper, we develop some properties of production and hedging behaviors when the competitive rm is not only risk averse but
also regret averse by assuming that the regret-averse rm has decided
to hedge. However, solving it is important and interesting to note
whether a regret-averse rm should hedge or not. To start answering
this issue, we develop proposition 8 to compare the optimal production
levels with and without the use of futures/forward contracts. In studying whether to hedge or not, one may compare the expected regretaverse utility functions under the optimal decisions with and without
hedging. In addition, we also note that the optimal choice of the
nancial hedging instruments (futures and options) is an interesting
extension of the theory with regret aversion developed in our paper
and others.3 We leave this to further study in the future.
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3
We would like to show our appreciation to the anonymous reviewer who point out
this problem.

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