Production organisation and risk control when market instruments are available

A standard result in the theory of production under price risk is that if forward cover is available, production is determined in terms of the known, quoted forward or futures price, rather than expectations of future prices. In practice, however, primary production often involves joint or substitutable products, so that a natural hedge may be available. In addition, costs such as input prices or interest rates are highly variable and may be correlated with output prices. Supply risk adds to this variation. This paper considers the demand for market-based hedging instruments in relation to such natural hedges and to the possible use of storage for hedging purposes. Under normality of conditional price/cost variation it is shown that for relatively arbitrary nonlinear production technologies and attitudes to risk, producers can plan production and derive their demand for futures by decomposing the organisation into a number of activity centres, involving planning, marketing, cost, and treasury functions. Adding up the hedging demands from each centre, and equating to the effective supply of each type of hedge (natural and market), yields a linear system that may be solved for the optimum quantities of each contract.