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

29 Pages Posted: 18 Sep 2015

See all articles by Taimaz Soltani

Taimaz Soltani

Eindhoven University of Technology (TUE) - Department of Industrial Engineering and Innovation Sciences

Arun Chockalingam

Eindhoven University of Technology (TUE) - Department of Industrial Engineering and Innovation Sciences

Jan C. Fransoo

Tilburg University - Tilburg University School of Economics and Management

Chung-Yee Lee

Hong Kong University of Science & Technology (HKUST) - Department of Industrial and Engineering and Logistics Management

Date Written: September 16, 2015

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.

Keywords: Freight options, Ocean freight, Commodity procurement, Value creation, OM-Finance Interface, Newsvendor model

Suggested Citation

Soltani, Taimaz and Chockalingam, Arun and Fransoo, Jan C. and Lee, Chung-Yee, Transporting Commodities: Hedging Against Price, Demand and Freight Rate Risk with Options (September 16, 2015). Available at SSRN: https://ssrn.com/abstract=2661571 or http://dx.doi.org/10.2139/ssrn.2661571

Taimaz Soltani

Eindhoven University of Technology (TUE) - Department of Industrial Engineering and Innovation Sciences ( email )

Den Dolech 2
Eindhoven
Netherlands

Arun Chockalingam (Contact Author)

Eindhoven University of Technology (TUE) - Department of Industrial Engineering and Innovation Sciences ( email )

Den Dolech 2
Eindhoven
Eindhoven, 5600 MB
Netherlands

HOME PAGE: http://home.tm.tue.nl/achockal/

Jan C. Fransoo

Tilburg University - Tilburg University School of Economics and Management ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

HOME PAGE: http://https://www.tilburguniversity.edu/staff/jan-fransoo

Chung-Yee Lee

Hong Kong University of Science & Technology (HKUST) - Department of Industrial and Engineering and Logistics Management ( email )

Clear Water Bay
Kowloon
Hong Kong

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