Title: Delivery Risk and the Hedging Role of Option
Reference Number: 1033
Publication Date: October 2001
JEL Classifcation: D81, G11

Donald Lien
University of Texas

Kit Pong Wong
The University of Hong Kong

Multiple delivery specifications exist on nearly all commodity futures contracts. Sellers are typically allowed to deliver any of several grades of the underlying commodity and at any of several locations. On the delivery day, the futures price as such needs not converge to the spot price of the par-delivery grade at the par-delivery location, thereby imposing an additional delivery risk on hedgers. This paper derives the optimal hedging strategy for a risk-averse hedger in the presence of delivery risk. In particular, it is shown that the hedger optimally uses options on futures for hedging purposes. This paper provides a rationale for the hedging role of options when futures markets allow for multiple delivery specifications.

Published in Journal of Futures Market 22:4, Aug 2002, pp. 339-354.

Key words: Futures, Options, Multiple delivery specifications

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Last modified: 01/23/2007