Hedging commodity procurement in a bilateral supply chain

This paper explores the merits of hedging stochastic input costs (i.e., reducing the risk of adverse changes in costs) in a decentralized, risk-neutral supply chain. Specifically, we consider a generalized version of the well-known "selling-to-the-newsvendor" model in which both the upstream and the downstream firms face stochastic input costs. The firms' operations are intertwined-i.e., the downstream buyer depends on the upstream supplier for delivery and the supplier depends on the buyer for purchase. We show that if left unmanaged, the stochastic costs that reverberate through the supply chain can lead to significant financial losses. The situation could deteriorate to the point of a supply disruption if at least one of the supply chain members cannot profitably make its product. To the extent that hedging can ensure continuation in supply, hedging can have value to at least some of the members of the supply chain. We identify conditions under which the risk of the supply chain breakdown will cause the supply chain members to hedge their input costs: (i) the downstream buyer's market power exceeds a critical threshold; or (ii) the upstream firm operates on a large margin, there is a high baseline demand for downstream firm's final product, and the downstream firm's market power is below a critical threshold. In absence of these conditions there are equilibria in which neither firm hedges. To sustain hedging in equilibrium, both firms must hedge and supply chain breakdown must be costly. The equilibrium hedging policy will (in general) be a partial hedging policy. There are also situations when firms hedge in equilibrium although hedging reduces their expected payoff.