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Hedging Commodity Price Risk

Published online by Cambridge University Press:  12 December 2022

Hamed Ghoddusi ,
Sheridan Titman Open the ORCID record for Sheridan Titman [Opens in a new window]  and
Stathis Tompaidis
Hamed Ghoddusi
Affiliation:
California Polytechnic State University Orfalea College of Business hghoddus@calpoly.edu
Sheridan Titman*
Affiliation:
University of Texas at Austin McCombs School of Business
Stathis Tompaidis
Affiliation:
University of Texas at Austin McCombs School of Business Stathis.Tompaidis@mccombs.utexas.edu
*
Sheridan.Titman@mccombs.utexas.edu (corresponding author)
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Abstract

We present an equilibrium model of hedging for commodity processing firms. We show the optimal hedge ratio depends on the convexity of the firm’s cost function and the elasticity of the supply of the input and the demand for the output. Our calibrated model suggests that hedging tends to be ineffective. When uncertainty comes exclusively from either the supply or from the demand side, updating the hedge dynamically, and using nonlinear contracts improves hedging effectiveness. However, with both supply and demand uncertainty, hedging effectiveness can be low even with option-based and dynamic hedging strategies.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 3 , May 2023 , pp. 1202 - 1229
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

We also thank participants and discussants for their input at seminars at HEC Montreal, Oxford Institute for Energy Studies, UTAustin, UC Berkeley, Humboldt University, Rutgers, Alberta Finance Institute Conference, BI Norwegian Business School, Athens University of Economics and Business, Sharif University of Technology, UC Davis, HEC Paris, University of Vienna, UQAM Montreal, the Commodity Futures Trading Commission (CFTC), the 2011 Applied Financial Economics conference, the 2011 International Conference on Mathematical and Financial Economics, the 2011 CFTC Conference on Commodities Markets, the 2012 Workshop on Probability and Statistics in Finance, the 2012 Alberta Finance Institute Conference on Speculation, Risk Premiums, and Financing Conditions in Commodity Markets, “the 2015 workshop on Commodities and Financialization at the Institute for Pure and Applied Mathematics, the 2019 Oklahoma University Energy and Commodities Finance Research Conference, and the 2019 Supply Chain Finance and Risk Management Workshop.”

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