Production decisions in the presence of options: A note

This paper examines the behavior of the competitive firm under uncertainty in the presence of commodity options. We show that the risk-averse firm always uses fairly priced commodity options for hedging purposes. However, unlike the case of forward/futures contracts, the presence of fairly priced commodity options cannot induce the firm to produce up to the certainty equivalent level. We further show that risk aversion alone is not enough to make the firm more eager to produce in the presence of fairly priced commodity options. To establish this intuitively appealing result, the notion of prudence is also called for.