Optimal corporate hedging using options with basis and production risk

• We study corporate hedging strategy using options with basis and production risk.
• The optimal option moneyness is affected by the hedging cash budget.
• Production risk largely affects hedging effectiveness.
• Basis risk drives the choice of the optimal option moneyness.
• Choosing a sub-optimal option moneyness leads to a non-negligible economic loss.

We investigate the optimal hedging strategy for a firm using options, where the role of production and basis risk are considered. Contrary to the existing literature, we find that the exercise price which minimizes the shortfall of the hedged portfolio is primarily affected by the amount of cash spent on the hedging. Also, we decompose the effect of production and basis risk showing that the former affects hedging effectiveness while the latter drives the choice of the optimal contract. Fitting the model parameters to match a financial turmoil scenario confirms that suboptimal option moneyness leads to a non-negligible economic loss.