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Integrated Commodity Inventory Management and Financial Hedging: A Dynamic Mean†Variance Analysis

Author

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  • Panos Kouvelis
  • Zhan Pang
  • Qing Ding
Abstract
We consider a firm purchasing a storable raw material commodity from a spot market with volatile commodity prices and the access to an associated financial derivatives market. The purchased commodity is processed into an end product with uncertain demand and lost sales. The firm aims to integrate the inventory replenishment and financial hedging decisions to maximize the mean†variance of terminal wealth over a finite horizon. Recognizing time†inconsistency of mean†variance criteria, we employ the dynamic programming approach to obtain a time†consistent policy. Assuming no arbitrage in financial market, we show that the mean†variance utility functions under the time†consistent policy have a recursive representation which enables us to readily characterize the structure of the time†consistent policy. We analyze two types of hedging instruments, vanilla hedges and exotic hedges, and show that inventory and financial hedging decisions can be separated in the presence of forward contracts and a myopic state†dependent base stock policy is optimal. The optimal hedging policy can be obtained by minimizing the variance of the hedging portfolio, the value of excess inventory and the profit†to†go as a function of future price. In the presence of a continuum of option strikes, we show how to construct custom exotic derivatives using forwards and options of all strikes to replicate the profit†to†go function. We then show the optimality of the time†consistent policy under exotic hedge for the initial mean†variance objective. We further investigate the dynamic interplay of inventories and financial hedge and show that they can be substitutes in a dynamic environment. Finally, we compare the performances in different hedging environments to discuss how financial hedges add value and provide a numerical study.

Suggested Citation

  • Panos Kouvelis & Zhan Pang & Qing Ding, 2018. "Integrated Commodity Inventory Management and Financial Hedging: A Dynamic Mean†Variance Analysis," Production and Operations Management, Production and Operations Management Society, vol. 27(6), pages 1052-1073, June.
    • Handle: RePEc:bla:popmgt:v:27:y:2018:i:6:p:1052-1073
    DOI: 10.1111/poms.12853
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    Cited by:

    1. Fan, Mengli & Xing, Wei & Huang, Yi, 2023. "Joint forward contract negotiation: The role of B2B procurement platforms," Journal of Business Research, Elsevier, vol. 167(C).
    2. Jiao Wang & Lima Zhao & Arnd Huchzermeier, 2021. "Operations‐Finance Interface in Risk Management: Research Evolution and Opportunities," Production and Operations Management, Production and Operations Management Society, vol. 30(2), pages 355-389, February.
    3. Sun, Xuting & Chung, Sai-Ho & Choi, Tsan-Ming & Sheu, Jiuh-Biing & Ma, Hoi Lam, 2020. "Combating lead-time uncertainty in global supply chain's shipment-assignment: Is it wise to be risk-averse?," Transportation Research Part B: Methodological, Elsevier, vol. 138(C), pages 406-434.
    4. Jianjun Xu & Mustafa Cagri Gürbüz & Youyi Feng & Shaoxiang Chen, 2020. "Optimal Spot Trading Integrated with Quantity Flexibility Contracts," Production and Operations Management, Production and Operations Management Society, vol. 29(6), pages 1532-1549, June.
    5. Choi, Tsan-Ming & Guo, Shu & Liu, Na & Shi, Xiutian, 2020. "Optimal pricing in on-demand-service-platform-operations with hired agents and risk-sensitive customers in the blockchain era," European Journal of Operational Research, Elsevier, vol. 284(3), pages 1031-1042.
    6. Jessica L. Darby & David J. Ketchen & Brent D. Williams & Travis Tokar, 2020. "The Implications of Firm‐Specific Policy Risk, Policy Uncertainty, and Industry Factors for Inventory: A Resource Dependence Perspective," Journal of Supply Chain Management, Institute for Supply Management, vol. 56(4), pages 3-24, October.
    7. Li Xia, 2020. "Risk‐Sensitive Markov Decision Processes with Combined Metrics of Mean and Variance," Production and Operations Management, Production and Operations Management Society, vol. 29(12), pages 2808-2827, December.
    8. Youngsoo Kim & Yuqian Xu, 2024. "Operational Risk Management: Optimal Inspection Policy," Management Science, INFORMS, vol. 70(6), pages 4087-4104, June.
    9. Anna Maria Gambaro & Nicola Secomandi, 2021. "A Discussion of Non‐Gaussian Price Processes for Energy and Commodity Operations," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 47-67, January.
    10. Ma, Shuai & Ma, Xiaoteng & Xia, Li, 2023. "A unified algorithm framework for mean-variance optimization in discounted Markov decision processes," European Journal of Operational Research, Elsevier, vol. 311(3), pages 1057-1067.
    11. Beatrice Marchi & Lucio Enrico Zavanella & Simone Zanoni, 2020. "Joint economic lot size models with warehouse financing and financial contracts for hedging stocks under different coordination policies," Journal of Business Economics, Springer, vol. 90(8), pages 1147-1169, September.
    12. Nicholas G. Hall & Zhixin Liu, 2023. "Scheduling with present bias," Production and Operations Management, Production and Operations Management Society, vol. 32(6), pages 1743-1759, June.
    13. Wei Xing & Shanshan Ma & Xuan Zhao & Liming Liu, 2022. "Operational hedging or financial hedging? Strategic risk management in commodity procurement," Production and Operations Management, Production and Operations Management Society, vol. 31(8), pages 3233-3263, August.
    14. Jena, Sarat Kumar & Padhi, Sidhartha S & Cheng, T.C.E., 2023. "Optimal selection of supply chain financing programmes for a financially distressed manufacturer," European Journal of Operational Research, Elsevier, vol. 306(1), pages 457-477.
    15. Bolandifar, Ehsan & Chen, Zhong, 2020. "Hedging through index-based price contracts in commodity-based supply chains," Omega, Elsevier, vol. 90(C).
    16. Canyakmaz, Caner & Özekici, Süleyman & Karaesmen, Fikri, 2024. "Risk management through financial hedging in inventory systems with stochastic price processes," International Journal of Production Economics, Elsevier, vol. 270(C).
    17. Yang, Honglin & Zhuo, Wenyan & Shao, Lusheng & Talluri, Srinivas, 2021. "Mean-variance analysis of wholesale price contracts with a capital-constrained retailer: Trade credit financing vs. bank credit financing," European Journal of Operational Research, Elsevier, vol. 294(2), pages 525-542.

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