A presentation based on the research paper "Hedging Commodity Procurement in a Bilateral Supply Chain" by Panos Kouvelis and Danko Turcic of Washington University in St. Louis.

1. to hedge or not to hedge: commodity
contracts and supply chains
Panos Kouvelis and Danko Turcic
September 24, 2015
Olin Business School, Washington University in St. Louis

2. Introduction
Many Industrial Firms are Exposed to Commodity Prices
Example
Food Company Kellogg’s is Exposed to Price Risks From:
∙ Corn, soybeans, sugar and cocoa that are used in its products
∙ Paper and plastics used in its packaging materials
∙ Natural gas used as energy in its manufacturing facilities
∙ Diesel fuel for transportation in its distribution network; and from
energy consumed in its offices and distribution centers
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3. Prices of Commodities Vary Over Time
Commodities are goods that are not differentiated in the
marketplace such as metals, energy, and agricultural products
Commodity prices are influenced by supply and demand as well as
by trading and speculation; thus, they can be highly volatile
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4. Volatility Wheel
PwC
Volatility Wheel
Source: Commerzbank
Major commodities
across agriculture,
energy and metals
have witnessed
continued price
volatility over the last
few years making
Commodity Price Risk
Management (CPRM)
a key priority for
companies.
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5. How Should Firms React?
Firm Respond to Price Volatility as Follows:
∙ Do nothing and absorb it
∙ Pass it onto their consumers (e.g., remember fuel surcharge in U.S.
taxi cabs)
∙ Build inventories can protect against price fluctuations
∙ Hedge using futures contracts
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6. What is Hedging?
https://www.youtube.com/watch?v=kBtrxAjtG04
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7. why should firms hedge?

8. Existing Thinking about Hedging
∙ The key to corporate value is making good investments
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9. Existing Thinking about Hedging
∙ The key to corporate value is making good investments
∙ The key to making good investments is generating enough cash
internally to fund these investments
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10. Existing Thinking about Hedging
∙ The key to corporate value is making good investments
∙ The key to making good investments is generating enough cash
internally to fund these investments
∙ Cash flow can often be disrupted by movements in external factors
(exchange rates, commodity prices)
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11. Existing Thinking about Hedging
∙ The key to corporate value is making good investments
∙ The key to making good investments is generating enough cash
internally to fund these investments
∙ Cash flow can often be disrupted by movements in external factors
(exchange rates, commodity prices)
∙ Disruptions may be hard to overcome with borrowing if firms face
frictions (taxes, bankruptcy costs, etc.)
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12. Existing Thinking about Hedging
∙ The key to corporate value is making good investments
∙ The key to making good investments is generating enough cash
internally to fund these investments
∙ Cash flow can often be disrupted by movements in external factors
(exchange rates, commodity prices)
∙ Disruptions may be hard to overcome with borrowing if firms face
frictions (taxes, bankruptcy costs, etc.)
A Goal of a Risk Management Program
Ensure that a company has the cash available to make value
enhancing investments
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13. Why Hedge?
Example: Omega Drug, a hypothetical multinational pharmaceutical
company
financial risk. What neither the company nor the
bankers have is a well-articulated view of the role of
risk management.
Thestartingpointforouranalysisisunderstand-
ing the link between Omega’s cash flows and its
strategic investments, principally its R&D program.
program. Therefore, fluctuations in the dollar’s ex-
change rate can be critical. If the dollar appreciates,
Omega will have a cash flow of only $100 million to
allocate to its R&D program—well below the desired
$200 million budget. A stable dollar will generate
enough cash flow for the program, while a depreci-
TABLE 1
PAYOFFS FROM OMEGA
DRUG’S R&D INVESTMENT
(IN MILLIONS OF DOLLARS)
TABLE 2
THE EFFECT OF HEDGING
ON OMEGA DRUG’S R&D
INVESTMENT AND VALUE
(IN MILLIONS OF DOLLARS)
R&D without Hedge Additional R&D Value from
The Dollar Internal Funds Hedging Proceeds from Hedging Hedging
Appreciation 100 100 +100 100 +130
Stable 200 200 0 0 0
Depreciation 300 200 -100 0 -100
R&D Level Discounted Cash Flows Net Present Value
100 160 60
200 290 90
300 360 60
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14. Why Hedge? (Continued)
Risk management lets companies transfer funds from situation in
which they have an excess supply to situations in which they have
shortage … borrow from themselves
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15. Existing Theory Does not Necessarily Explain Data
Empirical Studies
Either do surveys of hedging behavior or test extant theories.
Empirical Findings
∙ Firms may hedge when they do not face the obvious frictions
frictions (taxes, bankruptcy costs, etc.) and vice versa
∙ Firms may hedge in situations when hedging reduces their
expected profit
Factors not considered in the existing theories may driving firms’
hedging decisions.
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16. supply chain perspective of hedging

17. Commodities in Industrial Products
Panos&Kouvelis&- Emerson(Distinguished(Professor(of(Operations(&(Manufacturing(Management
Supply(Chain(Hedging
Model
e.g.&supply&chain&for&electric&motors
Supplier Manufacturer Uncertain/
Demand
Steel/price
Figure: Electric Motors at Emerson Electric
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18. Commodities in Industrial Products
Practices at Emerson Electric
∙ Sufficiently long lead times ⇒ price risk matters
∙ Contracts: price only and index contracts
∙ Financial hedging at the contract level, but not always
∙ Hedging behavior on the supply chain: Emerson hedges raw
materials for its garbage disposals that it sells to Home Depot
(thin margins)
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19. Commodities in Industrial Products
Practices at Emerson Electric
∙ Sufficiently long lead times ⇒ price risk matters
∙ Contracts: price only and index contracts
∙ Financial hedging at the contract level, but not always
∙ Hedging behavior on the supply chain: Emerson hedges raw
materials for its garbage disposals that it sells to Home Depot
(thin margins)
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20. Commodities in Industrial Products
Practices at Emerson Electric
∙ Sufficiently long lead times ⇒ price risk matters
∙ Contracts: price only and index contracts
∙ Financial hedging at the contract level, but not always
∙ Hedging behavior on the supply chain: Emerson hedges raw
materials for its garbage disposals that it sells to Home Depot
(thin margins)
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21. Commodities in Industrial Products
Practices at Emerson Electric
∙ Sufficiently long lead times ⇒ price risk matters
∙ Contracts: price only and index contracts
∙ Financial hedging at the contract level, but not always
∙ Hedging behavior on the supply chain: Emerson hedges raw
materials for its garbage disposals that it sells to Home Depot
(thin margins)
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22. Commodities in Auto Parts
Practices at BMW
∙ Index contracts (some indexes have long reset periods, > 1 year.)
∙ Rules vary by commodity (steel, plastic, leather, etc.) and by
supplier
∙ Financial hedging (at the firm level)
∙ No hedging at the contract level ⇒ BMW intentionally
consolidates the price risk downstream
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23. Main Issues That We Address
∙ In addition to direct purchases, commodities are embedded in
parts, components, products, and services purchased from
suppliers
∙ If commodity prices significantly increase
∙ the upstream supplier may not be able to fulfill contractual
requirements ⇒ risk for the buyer
∙ the downstream buyer may cancel orders ⇒ risk for the supplier
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24. Main Issues That We Address
∙ In addition to direct purchases, commodities are embedded in
parts, components, products, and services purchased from
suppliers
∙ If commodity prices significantly increase
∙ the upstream supplier may not be able to fulfill contractual
requirements ⇒ risk for the buyer
∙ the downstream buyer may cancel orders ⇒ risk for the supplier
Questions we Ask
∙ Can hedging improve supply chain performance?
∙ When would firms want to hedge?
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25. model

26. Model
Global Supply Chain Finance
Panos Kouvelis
Emerson Distinguished Professor of
Operations & Manufacturing Management
The Basic Setup
Figure: Supply Chain with Raw Material Procurement
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27. Key Assumptions
(i) Any default on the underlying supply contract is costly; neither
firm, however, stands to unusually profit from a default of its
supply chain partner.
(ii) Availability of futures contracts
(iii) To hedge means to buy n futures contracts for the underlying
commodity
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28. how should firms hedge?

29. SC Performance with no Hedging
Figure 3: Supply Chain with no Hedging
..
SC Breaks Down
.
SC Performs
.
S1
.
S2
.
(0, 0)
Figure 4: Supply Chain with Incorrect Hedging
Without hedging firms may be unable to produce when input costs
are too high
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30. SC with Insufficient Hedging
S1
(0, 0)
Figure 4: Downstream Manufacturer did not buy Enough Forward Contracts
..
SC Performs
.
Downstream Firm Breaks the
Contract Because it Cannot
Profitably Produce due to
High Input Costs
.
S1
.
S2
.
(0, 0)
Supplier is hedged, but the buyer is not
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31. SC with Insufficient Hedging
Figure 5: Downstream Manufacturer Bought too Many Forward Contracts
..
Downstream Firm Breaks the
Contract Because it Looses
Money on the Futures Con-
tracts and Cannot Cover
Production Costs.
SC Performs
.
S1
.
S2
.
(0, 0)
Figure 6: Supply Chain with Correct Hedging
Supplier is hedged, but buyer bought too many forward contracts
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32. Correctly Hedged Supply Chain
Figure 5: Supply Chain with Correct Hedging
..
SC Performs
.
S1
.
S2
.
(0, 0)
Both firms are hedged ⇒ hedging by going it alone does not work in
SC
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33. should hedging be expected in equilibrium?

34. Equilibrium: Assembler’s Expected Payoffs
Wholesale Prices with Hedging are Lower
A rational supplier gives a discount to a reliable buyer.
Downstream Firm’s Payoffs with Hedging are Higher
A hedged assembler pays a lower wholesale price and receives a
guarantees supply – provided that both firms manage risk (hedge)
Conclusion
Assembler always prefers to hedge.
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35. Equilibrium: Supplier’s Expected Payoffs
Uptream Firm’s Payoffs with Hedging are Higher – but only
sometimes...
(i) Downstream firm’s market power exceeds some critical
threshold ⇒ supplier may be forced into hedging
(ii) Downstream firm serves a large market while operating on a
small margin ⇒ hedging can be product dependent
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36. Guidelines for Managers
∙ Hedging depends on distribution of market power: Companies
should not necessarily adopt the same hedging strategy when
dealing with different supply chain partners
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37. Guidelines for Managers
∙ Hedging depends on distribution of market power: Companies
should not necessarily adopt the same hedging strategy when
dealing with different supply chain partners
∙ If market power is concentrated at the supply chain downstream,
our model predicts hedging
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38. Guidelines for Managers
∙ Hedging depends on distribution of market power: Companies
should not necessarily adopt the same hedging strategy when
dealing with different supply chain partners
∙ If market power is concentrated at the supply chain downstream,
our model predicts hedging
∙ For hedging to be effective, costly breakdown is required
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39. Guidelines for Managers
∙ Hedging depends on distribution of market power: Companies
should not necessarily adopt the same hedging strategy when
dealing with different supply chain partners
∙ If market power is concentrated at the supply chain downstream,
our model predicts hedging
∙ For hedging to be effective, costly breakdown is required
∙ Companies should pay close attention to the hedging strategy of
their supply chain partners: For hedging to be effective, all SC
must be actively managing risk
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40. Guidelines for Managers
∙ Hedging depends on distribution of market power: Companies
should not necessarily adopt the same hedging strategy when
dealing with different supply chain partners
∙ If market power is concentrated at the supply chain downstream,
our model predicts hedging
∙ For hedging to be effective, costly breakdown is required
∙ Companies should pay close attention to the hedging strategy of
their supply chain partners: For hedging to be effective, all SC
must be actively managing risk
∙ Supply Chain matters: It is possible for firms to hedge in a
(decentralized) supply chain and not hedge in a centralized supply
chain
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41. example: where do our result apply?

42. Commodities in Auto Parts
“Steel price increases creep
into supply chains,” WSJ, June
28, 2011
Hedging by going it alone
insufficient:
∙ Firms often become exposed
to commodity price risk
through their suppliers
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43. Questions?
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44. Summary
Get the source of this theme and the demo presentation from
github.com/matze/mtheme
The theme itself is licensed under a Creative Commons
Attribution-ShareAlike 4.0 International License.
cba
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