PRODUCTION FLEXIBILITY, STOCHASTIC SEPARATION, HEDGING, AND FUTURES PRICES

We study a dynamic model where uncertainty about interim output adjust ments causes producers to face price, cost and output uncertainty. Sto chastically separable production decisions are independent of the prod ucer's risk preferences and expectations and are based on the prevaili ng futures price as a certain output price. Conditions under which fut ures contracts achieve stochastic separation are established. Optimal hedging and maturity structure of futures contracts, equilibrium futur es prices, and the effects of futures trading on output are studied. T he systematic risk premium depends on the product of the futures beta and the covariance of the market return with production revenues.