Production, Hedging, and Speculative Decisions with Options and Futures Markets

Abstract

This paper analyzes production, hedging, and speculative decisions when both futures and options can be used in an expected utility model of price and basis uncertainty. When futures and option prices are unbiased, optimal hedging requires only futures (options are redundant). Options are used together with futures as speculative tools when market prices are perceived as biased. Straddles are used to speculate on beliefs about price volatility and to hedge the futures position used to speculate on beliefs about the expected value of the futures price. Mean-variance analysis in general is not consistent with expected utility when options are allowed. Key words: futures markets, hedging, options, price uncertainty, risk. One extension of Sandmo ' s expected utility model of the competitive firm under price un-certainty considers the use of futures or forward contracts. Danthine; Holthausen; and Feder, Just, and Schmitz show that without basis uncertainty the optimal output level is not affected by price risk; also, with an unbiased futures price, the optimal hedging level of the competitive firm is the full hedge, while a biased futures price will result in a partly speculative hedge. Related works include Batlin, who allows for basis risk in the form of imperfect time hedging; Paroush and Wolf, and Antonovitz and Nelson, who con-sider basis risk with the simultaneous availabil-ity of futures and forward contracts; Grant, Honda, Losq, Newbery and Stiglitz, and Rolfo, who allow for production uncertainty; Chavas and Pope, who allow for production uncertainty and hedging costs; and Karp, who considers the problem in a dynamic setting. This paper provides a further extension of this analysis by allowing options as a means of cop-ing with price risk. With the introduction of commodity options on futures for many com-modities in the 1980s, this problem appears re1-Harvey Lapan and Giancarlo Moschini are a professor and an as