Title: Production, Liquidity, and Futures Price Dynamics
Reference Number: 1175
Publication Date: August 2007
JEL Classifcation: D21, D81, G13
Author(s):

Kit Pong Wong
The University of Hong Kong

Abstract:

This paper examines the optimal design of a futures hedge program for the competitive firm under output price uncertainty. All futures contracts are unbiased and marked to market in that they require interim cash settlement of gains and losses. The futures price dynamics follows a first-order autoregression with a random walk serving as a special case. The firm's futures hedge program is constituted of an endogenous provision for premature termination, which depends on how the futures prices are autocorrelated. Succinctly, the firm voluntarily commits to premature liquidation of its futures position on which the interim loss incurred exceeds a predetermined threshold level if the futures prices are positively autocorrelated. In this case, the liquidity constrained firm optimally opts for an over-hedge if its preferences exhibit either constant or increasing absolute risk aversion. If the futures prices are uncorrelated or negatively autocorrelated, the firm prefers to be liquidity unconstrained and thus adopts a full-hedge to completely eliminate the output price risk.

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Key words: Endogenous liquidity, Futures hedging, Marking to market, Production

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Last modified: 09/06/2007