Risk management for a risk-averse firm with contingent payment

Abstract

This paper studies the contingent sales price risk mitigation problem of a risk-averse firm which procures some kind of commodity from the spot market as raw material for making certain product. The payment received by this firm depends on the underlying commodity spot price which is unknown until the product is physically delivered. In order to reduce the volatility stemming from the contingent payment, a financial hedging strategy requiring commodity futures contracts is proposed. This approach allows the firm to rebalance the commodity futures position dynamically. This study shows that the optimal strategy can be obtained when the firm adopts the exponential or mean-variance utility.