Optimal Investment and Production Across Markets with Stochastic Exchange Rates

Abstract:     
All multinational firms face foreign exchange fluctuations, which can create unstable cash flows and even bankruptcy. Managers of these firms face critical questions over how to reduce the risk due to income and expenses in multiple currencies. Traditional financial risk controls include futures and options, but firms also can use operational controls, such as foreign production capacity. In this paper, we study these alternatives for a simplified single-product firm operating in a home market and a foreign market. We show that a firm's optimal policy favors financial controls for low volatility exchange rates and the operational control of foreign production capacity for higher volatilities. We also show that, when the cost to switch production from one market to another involves a fixed cost plus a proportional charge on production, the optimal production policy either places all production entirely in one market or the other and that critical exchange ratios determine when to switch production to the favorable market. We model the problem in continuous time with production shifts appearing as jumps, leading to a form of impulse control problem. We introduce this methodology to operations management studies as an effective tool for analyzing continuous-review production systems with discrete decision outcomes.

Number of Pages in PDF File: 34

Keywords: Production investment, capacity, foreign exchange, impulse control

JEL Classification: C61, D24, G15, G31

working papers series