Optimum futures hedge in the presence of clustered supply and demand shocks, stochastic basis, and firm's costs of hedging

In a doubly stochastic jump‐diffusion economy with stochastic jump arrival intensity and proportional transaction costs, we develop a five‐factor risk‐return asset pricing inequality to model optimum futures hedge in the presence of clustered supply and demand shocks, stochastic basis, and firm's costs of hedging. Concave risk‐return tradeoff dictates a hedge ratio to be substantially less than the traditional risk‐minimization one. The ratio now comprises a positive diffusion, a positive jump, and a negative hedging cost component. The faster jumps arrive, and the more hedging costs, the more pronounced are the respective jump and hedging cost effects. Empirical validation confirms that actual industry hedge ratios vary significantly across firm's costs of and efficiency in hedging and are significantly lower than what risk‐minimization dictates. The model also can be used to compute a threshold production level for determining if a firm should hedge. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:1209–1237, 2003