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Rev Fin 1993; 6:935-957
© 1993 the Society for Financial Studies

Article

Production flexibility, stochastic separation, hedging, and futures prices

A Kamara
Graduate School of Business, DJ-10, University of Washington, Seattle, WA 98195, USA

Abstract

We study a dynamic model where uncertainty about interim output adjustments causes producers to face price, cost and output uncertainty. Stochastically separable production decisions are independent of the producer's risk preferences and expectations and are based on the prevailing futures price as a certain output price. Conditions under which futures contracts achieve stochastic separation are established. Optimal hedging and maturity structure of futures contracts, equilibrium futures prices, and the effects of futures trading on output are studied. The systematic risk premium depends on the product of the futures beta and the covariance of the market return with production revenues.


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