Integrated Options and Spot Procurement for Commodity Processors

Abstract

We consider a firm that procures a commodity through a combination of options and spot contracts to process it and then distribute it to the downstream retailers to satisfy random demand. This commodity is traded on an organized exchange where evolution of prices offers no risk-free arbitrage. The firm incurs transportation costs when exercising the physical delivery of the contracts. Transportation cost in the spot market is higher than in options markets because spot purchases need to be expedited through an expensive means of transportation. Commodity purchased through options contract arrives with a lead time of one period while spot procurement has a zero lead time. The objective of the firm is to maximize the value for its stakeholders in a multi-period model. We demonstrate that the procurement options create value for a firm by managing demand risk in the presence of transportation costs. We characterize the optimal policy for options procurement, options exercise, and spot buying/selling in a multi-period model. In addition, we identify conditions under which the options contracts are more valuable than the forward contracts for the firm. We show that the value of procurement through options contract increases with demand volatility and decreases with price volatility.

Keywords: Commodity Markets, Options, Procurement, Logistical Costs

JEL Classification: G13, D21, Q40