Transmission of Risk in a Supply Chain

Stathis Tompaidis
University of Texas at Austin

We develop an equilibrium model of price dynamics and the transmission of shocks in a supply chain. Starting with exogenous factors for the net supply of the upstream input and the demand for the downstream output, we determine the equilibrium price process for the input, the output, and the spread between input and output prices. We specify and calibrate our model for the case of crude oil and refined products that include gasoline and heating oil, and present comparative statics. As we show, the relative volatilities of oil and gasoline, as well as their correlation depends on the volatility and correlations of supply and demand shocks, elasticities, the convexity of the production function, and the competitiveness of gasoline markets. In our analysis of a two stage supply chain that transforms oil to fuel and fuel to air travel we find that airlines may be able to hedge profits more effectively using crude oil rather than jet fuel futures.

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