Integrating commodity futures in procurement planning and contract design with demand forecast update

Abstract

This study aims at investigating the benefits of integrating commodity futures contracts in devising commodity procurement policies as well as the design of supply contracts. To achieve this, a two-tier decentralised supply chain with uncoordinated risk transfer behaviours is studied. Specifically, the supply chain consists of a risk-neutral manufacturer (he) and a risk-averse retailer (she), where both players maximise their own objective functions by utilising the demand forecast update over the planning horizon. The mean-variance utility is employed to capture the retailer’s risk aversion behaviour.

For the first objective, this study considers a commodity procurement problem for the risk-neutral manufacturer. It shows that partially procuring in the forward market is potentially beneficial because the logistics costs tend to be larger for tighter delivery schedule and vice versa. Existing literature has studied the value of forward procurement. This study further explores the value of the dynamic adjustment in the forward (futures) market in response to the demand information update. Specifically, when the joint distribution of demand and new information is a bivariate normal distribution, the optimal procurement policy is characterized analytically. The second objective is studied within the supply chain setting, where the manufacturer is assumed to be the Stackelberg leader. Recently, various financial hedging strategies have been developed to mitigate the price risks for firms which directly procure commodities for their operations. However, few, if any, studies have addressed the integration of financial hedging with supply contract design so that the risk exposure faced by the downstream player in the supply chain could be partially hedged. Although the downstream retailer does not procure any commodity directly, she may suffer from the commodity price volatility propagated from the upstream manufacturer. By formulating the problem as a dynamic program, a flexible contract with time-consistent closed-form financial hedging policy is derived.

Numerical experiments are carried out to demonstrate the benefits gained by integrating the commodity futures contract with supply chain decision making. In the implementation, the short-term/long-term model developed by Schwartz and Smith is adopted to describe the stochastic behaviour of the price. Moreover, to preclude any risk-free arbitrage opportunity, the risk-neutral version of the model is employed. To take full advantage of the historical commodity price data, the smoother-based approach, rather than filter-based approach, is adopted to estimate the latent parameters of the stochastic price processes. For the manufacturer, it is shown that the value of the futures market is significant in the presence of logistics cost. Moreover, extra value could be obtained by adjusting the position in futures contracts in response to the newly observed information. For the decentralised supply chain, compared with the wholesale price contract, it is shown that the proposed flexible contract could improve the performance of the supply chain by leading to higher payoffs for both firms. Furthermore, the results show that flexible contract with financial hedging is effective on mitigating the commodity price risk exposure transferred from the manufacturer to the retailer when measured by standard deviation (SD), value-at-risk (VaR), and conditional VaR (CVaR).