The Impact of Delivery Risk on Optimal Production and Futures Hedging

19 Pages Posted: 1 Mar 2002

See all articles by Axel F. A. Adam-Muller

Axel F. A. Adam-Muller

University of Trier, Fachbereich IV - BWL

Kit Pong Wong

University of Hong Kong

Multiple version iconThere are 2 versions of this paper

Date Written: February 19, 2002

Abstract

Multiple delivery specifications exist on nearly all commodity futures contracts. Sellers are typically allowed to choose among several grades of the underlying commodity. On the delivery day, the futures price converges to the spot price of the cheapest-to-deliver grade rather than to that of the par-delivery grade of the commodity. This imposes an additional delivery risk on hedgers. This paper derives the optimal production and futures hedging strategy for a risk-averse competitive firm in the presence of delivery risk. We show that, depending on its relative valuation, the delivery option may induce the firm to produce more than in the absence of delivery risk. If delivery risk is additively related to commodity price risk, the firm will under-hedge its exposure to commodity price risk. If delivery risk is multiplicatively related to commodity price risk, the firm will under- or over-hedge this exposure. For constant relative risk aversion, this is illustrated by a numerical example.

Keywords: Delivery risk, futures, risk management, production

JEL Classification: G11, D81

Suggested Citation

Adam-Muller, Axel F. A. and Wong, Keith Kit Pong, The Impact of Delivery Risk on Optimal Production and Futures Hedging (February 19, 2002). Available at SSRN: https://ssrn.com/abstract=301373 or http://dx.doi.org/10.2139/ssrn.301373

Axel F. A. Adam-Muller (Contact Author)

University of Trier, Fachbereich IV - BWL ( email )

Trier, D-54296
Germany
+49-651-2012725 (Phone)
+49-651-201-3841 (Fax)

HOME PAGE: http://finance.uni-trier,de

Keith Kit Pong Wong

University of Hong Kong ( email )

Faculty of Business and Economics
University of Hong Kong
Hong Kong, Nil Nil
Hong Kong
(852) 2859-1044 (Phone)
(852) 2548-1152 (Fax)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
250
Abstract Views
1,928
rank
156,515
PlumX Metrics