How does aversion to intertemporal variation affect hedging behavior?

Abstract

Standard models of hedging behavior assume that hedgers wish to minimize net price variation. They treat variation as risk and fail to distinguish random variation at a specific point in time from pre-determined intertemporal variation. Recursive utility differentiates between random and nonrandom variation by allowing the elasticity of intertemporal substitution (EIS) to be imperfect. The inverse of the EIS measures the hedger's aversion to intertemporal variation and is distinct from aversion to risk. Optimal hedge ratios decline toward zero as aversion to intertemporal variation increases. These results may help explain why hedgers commonly hedge less than recommended by standard models.