Financial Hedging and Optimal Procurement Policies under Correlated Price and Demand. Issue 10 (19th July 2017)

• Record Type: Journal Article
• Authors: Goel, Ankur; Tanrisever, Fehmi
• Is Part Of: Production and operations management. Volume 26:Issue 10(2017)
• Page Start: 1924
• Page End: 1945
• Publication Date: 2017-07-19
• Subjects: integrated risk management -- financial hedging -- inventory management -- yield uncertainty -- myopic optima; Production management -- Periodicals; 658.505
• DOI: 10.1111/poms.12723
• Languages: English
• ISSNs: 1059-1478

Abstract

Abstract : We consider a firm that procures an input commodity to produce an output commodity to sell to the end retailer. The retailer's demand for the output commodity is negatively correlated with the price of the output commodity. The firm can sell the output commodity to the retailer through a spot, forward or an index‐based contract. Input and output commodity prices are also correlated and follow a joint stochastic price process. The firm maximizes shareholder value by jointly determining optimal procurement and hedging policies. We show that partial hedging dominates both perfect hedging and no‐hedging when input price, output price, and demand are correlated. We characterize the optimal financial hedging and procurement policies as a function of the term structure of the commodity prices, the correlation between the input and output prices, and the firm's operating characteristics. In addition, our analysis illustrates that hedging is most beneficial when output price volatility is high and input price volatility is low. Our model is tested on futures price data for corn and ethanol from the Chicago Mercantile Exchange.