Strategic use of futures and options by commodity processors

The impacts of input-output price relationships on end-users' demands for positions in futures and options are analyzed using a mean-variance portfolio model and applied to price risk management in the bread manufacturing industry. A production relationship was assumed between the input and resultant output, and correlation between the input and output prices were introduced into the portfolio model. The optimal hedge ratio can be either positive or negative depending upon the relationship between the input and output price standard deviation adjusted for production technology and input-output price correlation. Introduction of a call option into the portfolio (in addition to the futures) does not change the hedging demand for futures; however, the speculative component changes. The results show that the addition of input-output linear production and price correlation relationships would not justify a hedging role for options unless there is bias in the futures and/or options markets.