Production flexibility, stochastic separation, hedging, and futures prices

We study a dynamic model where uncertainty about interim outputadjustments causes producers to face price, cost and outputuncertainty. Stochastically separable production decisions areindependent of the producer's risk preferences and expectationsand are based on the prevailing futures price as a certain outputprice. Conditions under which futures contracts achieve stochasticseparation are established. Optimal hedging and maturity structureof futures contracts, equilibrium futures prices, and the effectsof futures trading on output are studied. The systematic riskpremium depends on the product of the futures beta and the covarianceof the market return with production revenues.