3

Integrating Physical and Financial Risk Management in Supply Management

Paul R. Kleindorfer

3.1 INTRODUCTION

This chapter provides a brief survey of recent contributions to the use of options and other derivative contract forms in support of commodity hedging and supply management in B2B markets. Such derivatives play an important role in integrating long-term and short-term contracting between multiple buyers and sellers in commodity markets. A primary question of interest in this context is hedging commodity risk exposure associated with commodity procurement decisions. In the usual context, Sellers compete to supply Buyers in a market in which, in the short run, capacities and technologies are fixed. Buyers can reserve capacity through contracts for physical delivery obtained from any Seller, and Buyers can also hedge these contracts through financial contracts on the same underlying indices from financial intermediaries. Output on the day can be either obtained through executing such contracts or in the associated spot market. Such contract-spot markets have become prominent under e-commerce (e.g. Geman, 2005), and include commodity chemicals, electric power, natural gas, metals, plastics, agricultural products, and basic foodstuffs.

Prior to the emergence of B2B exchanges and the contracting innovations of interest here, the focus in procurement and supply management was on bilateral negotiation, which gave rise to an extensive literature on various idiosyncratic aspects ...

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