HEDGING PRODUCTION RISK WITH OPTIONS

The expected utility maximization problem is solved for producers with both price and production uncertainty who have access to both futures and options markets. Introduction of production uncertainty alters the optimal futures and options position and almost always makes it optimal for the producer to purchase put options and to underhedge on the futures market. Simulation results lend support to the practice of hedging the minimum expected yield on the futures market and hedging remaining expected production against downside price risk using put options. The results are strengthened if the producer expects local production to influence national prices and if risk aversion is higher at low income levels.