Research seminar by Hamed Ghoddusi, Associate Professor at Orfalea College of Business, Cal Poly San Luis Obispo

Title: "Hedging Downstream: An Equilibrium View"

Abstract: Downstream firms face demand and supply shocks but usually lack access to direct financial derivatives like forwards to hedge. As a result, they seek alternative strategies, such as cross-hedging and vertical integration. We offer an equilibrium framework to analyze the effectiveness of optimal hedging strategies in these situations. Contrary to common belief, our friction-free linear model shows that financial hedging and vertical integration may offer limited hedging value due to the endogenous correlation of prices and spreads across the value chain. We introduce the notion of endogenous and exogenous volatility to rationalize these findings. We also show when frictions such as capacity constraints or multiple downstream markets are introduced, the hedging effectiveness increases as these factors weaken shock propagation and reduce the correlations between layers of the supply chain. We calibrate the theoretical model to examine quantitative implications. The paper presents a micro-founded model for making dynamic, forward-looking hedging decisions in environments where key relationships in the model are subject to change.