Options

Abstract

This chapter provides an overview of option markets and contracts as well as the basic valuation of options. Its primary purpose is to examine the behavior of the competitive firm that faces not only output price uncertainty but also a multiplicative revenue shock. The firm can trade fairly priced commodity futures and option contracts for hedging purposes. This chapter shows that neither the separation theorem nor the full-hedging theorem holds when the revenue shock prevails. The correlation between the random output price and the revenue shock plays a pivotal role in determining the firm’s optimal production and hedging decisions. If the correlation is non-positive, the firm optimally produces less than the benchmark level in the absence of the revenue shock. Furthermore, the firm’s optimal hedge position includes both the commodity futures and option contracts. However, if the correlation is sufficiently positive, a canonical example is constructed under which the firm optimally produces more, not less, than the benchmark level. The firm as such uses operational and financial hedging as complements to better cope with the multiple sources of uncertainty.