Dynamic Risk Management of Commodity Operations: Model and Analysis

Manufacturing & Service Operations Management, Forthcoming

46 Pages Posted: 3 May 2014 Last revised: 10 Sep 2017

See all articles by Sripad K. Devalkar

Sripad K. Devalkar

Indian School of Business

Ravi Anupindi

University of Michigan, Stephen M. Ross School of Business

Amitabh Sinha

University of Michigan, Stephen M. Ross School of Business

Date Written: April 28, 2017

Abstract

Adverse commodity prices can cause significant negative cash flows and expose firms that deal in commodities to financial distress. In this paper we consider the dynamic risk management problem for a commodity processor operating in a partially complete market, facing both price uncertainty and significant financial distress costs. The firm procures an input commodity, processes it to produce an output commodity, and trades the output commodity in each period over a multi-period horizon. The firm's objective is to dynamically and jointly plan operational and financial hedging decisions to maximize the market-based value of cash flows under a time-consistent risk measure. We show that the optimal operational policy has the same price and horizon dependent threshold structure that obtains when markets are complete. We also characterize conditions under which a myopic policy is optimal. We present numerical studies to illustrate that: (i) compared to using a myopic policy or a policy that neglects to model financial distress costs, the advantage of using the optimal policy is significant for firms that face moderate financial distress costs and have excess procurement capacity, (ii) more acute financial distress costs reduce the firm's market-based value and throughput, and (iii) financial hedging provides considerable benefit by reducing the incidence of large negative cash flows.

Keywords: Risk management, storable commodities, time-consistent risk measures, partially complete markets

Suggested Citation

Devalkar, Sripad K. and Anupindi, Ravi and Sinha, Amitabh, Dynamic Risk Management of Commodity Operations: Model and Analysis (April 28, 2017). Manufacturing & Service Operations Management, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2432067 or http://dx.doi.org/10.2139/ssrn.2432067

Sripad K. Devalkar (Contact Author)

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

Ravi Anupindi

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734.615.8621 (Phone)

HOME PAGE: http://michiganross.umich.edu/faculty-research/faculty/ravi-anupindi

Amitabh Sinha

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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