Forward Markets and the Behaviour of the Competitive Firm with Production Flexibility

Author: Wong K.P.

Source: Bulletin of Economic Research, Volume 55, Number 3, July 2003 , pp. 303-310(8)

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Abstract:

This paper examines the production and hedging decisions of the competitive firm under output price uncertainty when a forward market for its output is available. The firm possesses production flexibility in that it makes its production decision after the resolution of the output price uncertainty, albeit subject to a capacity constraint on production. We show that the firm optimally acquires a higher level of capacity investment than an otherwise identical firm with no production flexibility. We further show that production flexibility allows the firm to implicitly hedge against its output price risk exposure by the ex post production decision. The firm as such under-hedges its output price risk exposure in the forward market wherein the forward price contains a non-positive risk premium.

Keywords: forward markets; production flexibility; D21; D81

Document Type: Research article

DOI: http://dx.doi.org/10.1111/1467-8586.00177

Affiliations: 1: University of Hong Kong

Publication date: 2003-07-01