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A multi-stage financial hedging approach for the procurement of manufacturing materials

https://doi.org/10.1016/j.ejor.2012.03.031Get rights and content

Abstract

This paper addresses the problem of mitigating procurement risk that arises from volatile commodity prices by proposing a hedging strategy within a multi-stage time frame. The proposed multi-stage hedging strategy requires a commodity futures position to be correctly initialised and rebalanced with adequate volumes of short/long positions, so as to reduce the volatility in the total procurement cost that would otherwise be generated by varying commodity spot prices. The novelty in the approach is the introduction of the rebalancing of commodity futures position at defined intermediate stages. To obtain an efficient or near optimal multi-stage hedging strategy, a discrete-time stochastic control model (DSCM) is developed. Numerical experiments and Monte Carlo simulation are used to show that the proposed multi-stage hedging strategy compares favourably with the minimal-variance hedge and the one-stage hedge. A close-form optimal solution is also presented for the case when procurement volume and price are independent.

Highlights

► We develop a hedging strategy to deal with uncertain demand and price fluctuation. ► We use tradable commodities as the tool for hedging. ► The risk hedging model is based on discrete-time control theory. ► Futures positions are adjusted in response to price and demand movements. ► The approach outperforms hedging models without rebalancing of futures positions.

Section snippets

Introduction and review of relevant literature

Relatively stable commodity and raw materials prices are obviously preferred for production and business operations, but unfortunately, manufacturers are continuously forced to face highly volatile prices, especially in recent years. Such price volatility is in part due to variations in supply and demand, but excessive speculation, which has become a normal part of modern markets, has significantly increased price volatility and in turn the complexity of the procurement problem. According to

Formulation of the procurement risk mitigation problem

A multi-stage financial hedging strategy is proposed that performs a hedge against the uncertain procurement cost. The entire planning horizon is divided into several stages, depending on the frequency of rebalancing desired by the company management. The multi-stage financial hedging strategy consists of the initial futures position and the subsequent rebalancing and adjustment of the position. At the beginning of the planning horizon, the company will first take an initial position in the

Problem solution

The best solution for DSCM model will in fact be the optimal multi-stage financial hedging strategy. First, we analyse the model when L is the utility for a given R¯:L=R¯-12αR¯2Since R¯ is a function of the hedging strategy, Y={yt}t=0T-1,L will also be a function of Y. If L^t is the conditional expected value of L at stage t + 1, then the optimal hedging strategies yt+1,,yT-1 after stage t are:L^t=ELyt+1,,yT-1Ft+1,0t<T-1L,t=T-1The optimal, yt, is the one that maximise the value E[L^t|Ft].

Numerical experiments

In this section, the proposed multi-stage hedging strategy is assessed by a comparative study and a sensitivity analysis. The study compares the proposed approach with other hedging strategies that do not perform any futures position rebalancing. The sensitivity analysis assesses the effects of changes in commodity price and/or procurement volume volatilities on the hedging strategy.

The comparison between the proposed multi-stage hedging strategy and a single hedging strategy can be easily done

Concluding remarks

A financial hedging approach was presented in this paper that mitigates the procurement risk arising from volatile commodity prices. To deal with uncertainties in procurement volume and price, a discrete-time stochastic control model was developed and tested, and an economic replenishment strategy was obtained for a multi-stage financial commodity futures hedging. Numerical results obtained from the Monte Carlo simulation showed that the multi-stage financial hedging strategy obtained from the

Acknowledgement

The authors are grateful to the support provided by the National Natural Science Foundation of China (NSFC No. 71071126).

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