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Transporting Commodities: Hedging Against Price, Demand and Freight Rate Risk with Options

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Document pages: 29 pages

Abstract: Like options on stocks, options on commodities provide firms with protection against adverse price movements. Many firms procure commodity at an offshore location and transport it via ocean freight. Increased globalization and increased demand for ocean-based transportation has resulted in ocean freight itself becoming a volatile commodity. We consider a commodity processor and develop models to determine the firm’s optimal hedging policy. The models allow for three sources of uncertainty; demand, commodity spot price and freight rate. The scenarios differ based on assumptions on independence between the uncertainties, and also assumptions on market competitiveness. The optimal hedging policies are variants of the classical newsvendor critical fractile. We show that partially procuring the commodity and its freight through option contracts, rather than entirely on the volatile spot market creates value, even for a risk-neutral firm. We then perform extensive numerical experiments to study the influence of the underlying parameters on the optimal hedging policies and value creation.

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