Effect of Term Structure Model of Futures Price on Procurement Policies

Abstract

The commodity futures price information conveyed by organized exchanges can be used by commodity processors to improve their procurement process. A practical obstacle in the utilization of this information is that the maturity dates of the traded contracts on the exchange and the decision cycle of commodity processors are not synchronized. In this paper, we develop a modeling framework that incorporates the dynamically evolving futures prices to negotiate forward contracts with their supplier. In particular, the pricing of these forward contracts are critical when their delivery dates are not synchronized with the maturities of the futures contracts traded on the exchange. In addition, we propose a systematic approach to model the trade-offs involved in commodity procurement and to incorporate the latest market prices in the development of optimal procurement polices. To test our models we use two well known models of commodity prices with increasing levels of complexity and precision. We use historical futures prices from CBOT (Chicago Board of Trade) and NYMEX (New York Mercantile Exchange) for wheat and unleaded gasoline respectively, to fit the price model parameters, and to test the inventory model on actual out of sample market prices. Our findings suggest that significant benefits are derived from incorporating systematically the latest futures prices on price models of increased precision.

Keywords: Stochastic price models, Commodity markets, Inventory management, Marginal convenience yield