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Unformatted text preview: Use of Inventory and Option Contracts to Hedge Financial Risk in Planning Under Uncertainty Andres Barbaro and Miguel J. Bagajewicz School of Chemical Engineering and Materials Science, University of Oklahoma, Norman, OK 73019 DOI 10.1002/aic.10095 Published online in Wiley InterScience (www.interscience.wiley.com). The use of inventory and options in the management of financial risk in planning under uncertainty is analyzed. The intuitive notion that the addition of inventory can reduce risk is explored to reveal that it is only guaranteed if models managing risk are used and can otherwise lead to higher risk exposures. An example where risk is managed with options contracts is also presented, revealing that risk is also hedged only through an approach where risk is properly managed but not necessarily every time options are used. 2004 American Institute of Chemical Engineers AIChE J, 50: 990998, 2004 Keywords: Planning, financial risk, robust optimization Introduction Barbaro and Bagajewicz (2004) discussed the importance of process planning under uncertainty, and presented a two-stage stochastic programming framework to manage risk. To do so, they defined risk formally. They also used downside risk (Ep- pen et al., 1989) to show how one can manage risk in planning under uncertainty. A multiobjective framework was proposed. In industrial practice, it is well recognized that maintaining a certain level of inventory may certainly soften the impact of price, availability, and demand variations on the profitability of the operations. In this article, the effect of inventory on finan- cial risk is analyzed for the test problem presented by Barbaro and Bagajewicz (2004). The idea is then to show how the risk curves behave when inventory of products and raw material are allowed. For this purpose, a simple adaptation of the process planning model PP was considered. The other common mechanism to hedge risk is the use of financial contracts. Among this class of instruments are the futures and option contracts, which are often referred as deriv- atives (Hull, 1995). A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price. In turn, there are two basic kinds of option contracts: calls and puts. On the other hand, a put option gives the holder the right to sell an asset by a certain date and for a certain price. However, a put option gives the holder the right to sell an asset by a certain date and for a certain price. These contracts are traded daily in many exchanges, such as the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CMB), the New York Futures Exchange (NFE), and the New York Mer- cantile Exchange (NYMEX) among others....
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