Risk Management and Real Options with Operating Hedging Contracts

Abstract:     
The real options literature largely abstracts away from active risk management by firms. In this paper, we jointly examine the capacity investment choice and risk management strategy of upstream firms in vertically separated industries that possess costly expansion options but face demand uncertainty from the downstream sector. A novel, but realistic, feature of our analysis is that upstream firms also have the option to hedge the demand uncertainty by fixing the terms of future trade through bilateral operating contracts with downstream firms. The operating hedging contract eliminates the upstream firm's expansion option, but may enhance overall industry profits by improving coordination between the upstream and downstream firms. We show that, in equilibrium, it is optimal for upstream firms to relinquish the expansion option when demand uncertainty is low and the expansion cost is high. A key insight of our paper is that hedging through operating contracts may be optimal even when firms are risk neutral, and are not subject to any financial distress costs or external financing constraints.

Number of Pages in PDF File: 43

Keywords: risk management, real options, irreversible investments, operating contracts, vertical industry

JEL Classification: G30, G31, L11, L14, L22

working papers series