Centre for Discrete and Applicable Mathematics
	CDAM Research Report, LSE-CDAM-98-03 February 1998

Abstract

An important category of costs that management need to plan for and control are the costs associated with the purchase of direct inputs. Traditional operations management approaches model this problem as requiring management to direct attention to the trade-off between inventory holding costs versus stock out and back ordering costs. However, when derivative positions can be held on inventory, management can purchase claims which do not give rise to holding costs and hence the traditional analysis of the problem requires augmentation. Our principal concern in this research is to develop guidelines for the financial management of input derivatives when prices are volatile and expected to increase. A principal result is the derivation of an optimal hedging policy for accounting profit. Moreover, we show that the derived optimal hedging policy has a simple intuitive interpretation. It requires derivatives positions to be taken which insure that next period returns never fall below a predetermined optimal `floor' level. That is, our analysis provides constructive guidelines to help financial management decide upon which derivatives positions to hold.

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