Production decision under risk: A decision analysis approach incorporating multi-layered options

Zhang Hua

Abstract

This research examines how firms choose input quantity and make use of financial instruments to minimize risks arising from price uncertainties. Futures contracts are most commonly used by producers who face both price and production uncertainty. Recently the use of options is becoming more popular. Existing literatures have examined mostly the use of "put" options with a single strike price adopted by commodity producer. With the well-established financial markets nowadays, producers can better protect themselves by choosing options with different strike prices and at different premiums. This thesis will look at possible ways of hedging the risks by using multi-layered "put" options and hedging using "call" options. In addition, decision analysis tool is applied to risk management in this context, instead of the traditional mean-variance theoretical analysis. Four models have been developed in this thesis. Results are obtained and compared using decision analysis tool.

The proposed model has shown that with multiple strike prices and premiums of option, the farmer is able to reduce his risk exposure significantly. However, we have to bear in mind that the choice of put or call options and the hedging decision are mainly dependent on the producer's subjective expectation of futures price and his attitude towards risks. The generalized result from most of the existing works shows that the producer will purchase put options and under-hedge on the futures market. Although this research focuses mainly on agricultural production, the use of financial instruments in risk management can be actually applied to any manufacturers in general.