Financial Hedging and Optimal Procurement Policies Under Correlated Price and Demand

Abstract

We consider a firm that procures an input commodity to produce an output commodity to sell to the end retailer. 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 either through a spot or a forward contract. Input and output commodity prices are also correlated and follow a joint stochastic price process. The firm maximizes the value of its stakeholders by jointly determining the optimal procurement policy of the input commodity, and the financial hedging policy for the sales of the output commodity. We show that partial hedging dominates both perfect hedging and no-hedging when input price, output price, and demand are correlated, and we characterize this optimal hedging policy. We identify sufficient conditions under which myopic policy is optimal for the price taking firm. We also show that expected base-stock policy is optimal in the presence of yield uncertainty. 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 the futures price data between 4/1/2005 to 12/31/2011 from Chicago Board of Trade (CBOT) for corn and ethanol.

Keywords: Hedging, Inventory, Yield Uncertainty, Myopic Optima