The Optimal Hedging Strategy for Commodity Processors in Supply Chain

Abstract

This paper studies the optimal hedging strategies for risk neutral players in a competitive supply chain setting. We consider two processors procuring two commodities from spot markets to process and sell through index-based contracts to a retailer. Commodity prices are stochastic and correlated. The retailer is facing price sensitive demand curves so it controls its market demands through market pricing. First, we characterize the optimal index-based contracts for processors which implies that processors prefer to be exposed to commodity price risks. We show that the processor‘s optimal contract consists of a processing margin which is independent of its financial hedging decisions and a hedge ratio which is a function of commodity price volatility. We show that processors can benefit from market pricing, when these prices are linked to input commodity prices and index-based contracts are a means to link these prices. We also explore how commodity and product market parameters affect optimal hedging decisions.