Managing Storable Commodity Risks: The Role of Inventory and Financial Hedge

Panos Kouvelis (), Rong Li () and Qing Ding ()
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Panos Kouvelis: Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130
Rong Li: Olin Business School, Washington University in St. Louis, St. Louis, Missouri 63130; and Nankai Business School, Nankai University, 300071 Tianjin, China
Qing Ding: Lee Kong Chian School of Business, Singapore Management University, Singapore 178899

Manufacturing & Service Operations Management, 2013, vol. 15, issue 3, 507-521

Abstract: We study how to manage commodity risks (price and consumption volume) via physical inventory and financial hedge in a multiperiod problem (with an interperiod utility function) for a risk-averse firm procuring a storable commodity from a spot market at a random price and a long-term supplier at a fixed price. The firm also has access to financial contracts written on the commodity price, such as futures contracts and call and put options. We examine different cases of financial hedging, for example, single-contract and multicontract hedges. For each case, we dynamically maximize the mean-variance utility of the firm's cash flow and characterize an optimal integrated policy of inventory and hedging, which is easy to compute and implement. We find that as long as futures are used in each period, alone or not, the optimal inventory policy is myopic. The optimal hedging policy, however, is never myopic, but depends on all the future optimal decisions. This is contrary to findings of the literature using intraperiod utility functions, which finds myopic hedging to be optimal. Moreover, we find that hedging may lead to inventory reduction in multiperiod problems. Thus the insights from the single-period studies in the literature—hedging leads to inventory increase—do not apply. Finally, insights are offered on the role and impact of inventory and financial hedge on profitability, variance control, and service level, using both analytical and numerical results.

Keywords: stochastic inventory; commodity markets; futures; options; risk management; hedging; risk aversion (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (29)

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