Financial Hedging Decisions on Procurement Risk with Value-at-Risk Consideration

Abstract

We study how to manage commodity risks (price and volume) via procurement and financial hedging for a value-at-risk (VaR) risk-averse newsvendor. Facing stochastic procurement cost from the commodity market, the firm decides on its financial hedging strategy contingent on the procurement cost with continuous strike prices. After the realization of the procurement cost, the firm determines the order quantity under demand uncertainty. We derive closed-form solution of the joint optimal order quantity and financial hedging policy, which is proved to be time-consistent and risk-coherent. Furthermore, we show how financial hedging turns risks into rewards by rebalancing the payoffs under different spot price realizations, thus characterizing the value of financial hedging. We investigate the effects of these two parameters of VaR, i.e., the tolerance level divides the decision region into two that tends toward over-spending or short-spending, respectively. The profit reservation level lowers the risk-neutral order quantity in the over-spending region but raises it in the short-spending region. Numerical studies show that procurement cost uncertainty may improve the expected profit due to our comprehensive hedging policy and postponed order decision. The interaction between the operational and financial decision presents more value in the scenarios where there are a volatile demand and a negative correlation between demand and procurement cost.

Keywords: commodity risk management, procurement, financial hedging, value-at-risk, portfolios