Equilibrium Forward Contracts on Nonstorable Commodities in the Presence of Market Power

43 Pages Posted: 22 Nov 2003

See all articles by Hong Liu

Hong Liu

Washington University in St. Louis - Olin Business School; Fudan University - China Institute of Economics and Finance

Lingxiu Dong

Washington University in St. Louis - John M. Olin Business School

Abstract

Bilateral supply contracts are widely used despite the presence of spot markets. In this paper we provide a potential explanation for this prevalence of supply contracts even when spot markets are liquid and without delivery lag. Specifically, we consider the determination of an equilibrium forward contract on a nonstorable commodity between two firms that have mean-variance preferences over their risky profits and negotiate the forward contract through a Nash bargaining process. We derive the unique equilibrium forward in closed form and provide an extensive analysis of the equilibrium contract. We show that it is the risk hedging benefit from a forward that justifies its prevalence in spite of liquid spot markets. In addition, while a forward does not affect production decisions due to the presence of spot markets, it does affect inventory decisions of the storable input factor due to its hedging effect against the inventory risk. We also show that price volatilities and correlations are important determinants of the equilibrium contract. In particular, the equilibrium forward price can be nonmonotonic in the spot price volatility and can decrease as the initial spot price increases.

Keywords: Forward Contract, Open Interest, Nonstorable, Electricity, Market Power

JEL Classification: D11, D91, G11, C61

Suggested Citation

Liu, Hong and Dong, Lingxiu, Equilibrium Forward Contracts on Nonstorable Commodities in the Presence of Market Power. Available at SSRN: https://ssrn.com/abstract=471741 or http://dx.doi.org/10.2139/ssrn.471741

Hong Liu (Contact Author)

Washington University in St. Louis - Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-5883 (Phone)

Fudan University - China Institute of Economics and Finance ( email )

China

Lingxiu Dong

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

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