Managing Revenue Risk of the Firm: Commodity Futures and Options

Abstract

This paper examines the behavior of the competitive firm that faces not only output price uncertainty but also a revenue shock. The firm can trade fairly priced futures and put option contracts for hedging purposes. We show that neither the separation theorem nor the full-hedging theorem holds when the revenue shock prevails. The correlation between the random output price and the revenue shock plays a pivotal role in determining the firm's optimal production and hedging decisions. If the correlation is non-positive, the firm's optimal output level is smaller than that without the revenue shock. Furthermore, the firm's optimal hedge position consists of an under-hedge and a long put option position if the firm's preferences exhibit prudence. The prevalence of revenue risk as such makes financial and operational hedging act as complements to better cope with multiple sources of uncertainty.