“Production Flexibility and Hedging” by Keith K. P. WONG
Keith K. P. WONG
University of Hong Kong
This paper studies the interaction of real and financial options in the context of the competitive firm under output price uncertainty. The firm possesses production flexibility in that it makes its production decision after observing the realized output price, albeit subject to a capacity constraint on production. We show that production flexibility endows the firm with a real option to contract. The ex post exercising of this real option gives rise to additional ex ante uncertainty which imposes a convex component on the firm's output price risk exposure. This convexity induces the firm to opt for a concave payoff risk-sharing rule, thereby rationalizing the hedging role of options. We further show how a portfolio of unrestricted plain vanilla derivatives (i.e., futures and options) can be constructed to achieve the first-best risk-sharing outcome. Even in the case that the available plain vanilla derivatives are limited, we show that allowing the firm to trade these contracts for hedging purposes always enhances its incentives to produce.