Risk Management in Commodity Processing Firms

We introduce an equilibrium view of profit hedging in a representative commodity processing industry. The commodity processor takes shocks to the supply of the primary commodity and the demand for the processed commodity as given and chooses the optimal quantity of production. Such a model generates an endogenous stochastic profit stream for the processor, which is possibly substantially different than input and output prices. Thus, absent financial instrument specifically on the spread, hedging input or output prices alone may only provide poor partial hedging to the processor.