Strategic forward contracting and observability

Recently, Allaz (1992) characterized strategic and hedging incentives for entering forward contracts in a two-stage duopoly setting under the implicit assumption that positions in forward contracts are publicly observable. However, credible disclosure of such positions is, at best, costly and subject to noise. Our purpose in this paper is to examine the effects of observability on the interdependency between strategic and hedging behavior. First, focusing on an Allaz-type setting with Cournot conjectures at both stages, we show that if forward positions are unobservable and the hedging motive is not present, i.e., risk neutrality, then the strategic incentive disappears. In fact, contrary to Allaz, each producer strictly prefers not to engage in forward contracting. However, given that a hedging motive is present, we show that producers engage in forward contracting not only to hedge, but also to exploit the awareness of that motive by their rival. In this case, they behave strategically notwithstanding the absence of observability. We then extend the analysis beyond Allaz's setting to consider cases in which uncertainty relates to cost and resolution of uncertainty follows rather than precedes production. When cost uncertainty is resolved before production decisions are made, we show that a hedging motive induces forward positions in the opposite direction to those motivated by strategic incentives and more so in the absence of observability. Lastly, when cost uncertainty is resolved after production, we show that the hedging motive disappears and producers only engage in forward contracting when their positions are observable. Our analysis is relevant to financial reporting practices governing the disclosure of forward contracts.