Optimal Managerial Compensation and Financial Hedging in Commodity Procurement

The procurement of commodities, such as basic raw materials and energy sources, is an important operations management activity that can significantly impact the value of a firm. Managing commodities may also include trading of commodities' contracts on the financial markets. The finance and economics literature suggests that financial hedging is a valuable risk management strategy because it can reduce the agency cost. We elaborate on this idea by studying the interaction between financial trading and physical trading decisions within a firm from the principal-agent perspective. This interaction creates tension between the compensation that the firm provides to the procurement manager responsible for physical trading and the financial hedging decision of the firm: a higher bonus rate makes the procurement manager exert more effort, which reduces the variability of the commodity price and reduces the need for hedging. As a result of this tension, we find that the bonus rate is non-monotonic in several parameters that characterize the firm and the manager, such as the average commodity price and the ability level of the manager. We also find that only medium sized companies engaged in commodity procurement should use financial hedging to reduce agency costs.