Optimal hedging when preferences are state dependent

A simple model is presented to show how optimal hedging strategies are affected by state-dependent preferences. In particular, futures-market contracts might have an ability to hedge not only against price fluctuations for an owned asset, but also against changes in the consumption-opportunity set that arise from changing prices. In the simple model, where all correlations are perfect, the individual fully insures in the futures market whenever futures prices are unbiased and marginal utility is state independent. The optimal hedge is shown to have 3 components. In the simple model, the first component fully eliminates price risk for the owned asset (the pure-hedge component), the 2nd deviates from the pure hedge to eliminate risk associated with changes in the consumption-opportunity set (the price-compensation component), and the 3rd deviates from the reference set whenever futures prices are biased (the speculative component).