Operational Hedging and Diversification under Correlated Supply and Demand Uncertainty

Production and Operations Management, Volume 23, Issue 7, pages 1212–1226, July 2014

Posted: 30 May 2011 Last revised: 15 Dec 2015

See all articles by Fabian J. Sting

Fabian J. Sting

Erasmus University - Rotterdam School of Management

Arnd Huchzermeier

WHU - Otto Beisheim School of Management

Date Written: July 1, 2014

Abstract

When facing supply uncertainty caused by exogenous factors such as adverse weather conditions, firms diversify their supply sources following the wisdom of “not holding all eggs in one basket.” We study a firm that decides on investment and production levels of two unreliable but substitutable resources. Applying real options thinking, production decisions account for actual supply capabilities, whereas investment decisions are made in advance. To model triangular supply and demand correlations, we adapt the concepts of random capacity and stochastic proportional yield while using concordant ordered random variables. Optimal profit decreases monotonically in supply correlation and increases monotonically in supply–demand correlation. Optimal resource selection, however, depends on the trivariate interplay of supply and demand and responds non-monotonically to changing correlations. Moreover, supply hedges (i.e., excess capacity at alternative sources) can be optimal even if supply resources are perfectly positively correlated. To accommodate changing degrees of correlation, the firm adjusts the lower margin capacities under random capacity; but under stochastic proportional production capability, it uses either low- or high-margin capacities to create tailored “scale hedges” (i.e., excess capacity at one source which can partially substitute for diversification).

Keywords: trivariate supply and demand risk, operational hedging, diversification, concordance order, correlation

Suggested Citation

Sting, Fabian J. and Huchzermeier, Arnd, Operational Hedging and Diversification under Correlated Supply and Demand Uncertainty (July 1, 2014). Production and Operations Management, Volume 23, Issue 7, pages 1212–1226, July 2014 , Available at SSRN: https://ssrn.com/abstract=1853226 or http://dx.doi.org/10.2139/ssrn.1853226

Fabian J. Sting (Contact Author)

Erasmus University - Rotterdam School of Management ( email )

Erasmus University
PO Box 1738
3000 DR Rotterdam, Zuid-Holland
Netherlands

HOME PAGE: http://www.rsm.nl/fsting

Arnd Huchzermeier

WHU - Otto Beisheim School of Management ( email )

Burgplatz 2
Vallendar, 56179
Germany
+49-261-6509380 (Phone)
+49-261-6509389 (Fax)

HOME PAGE: http://www.whu.edu/prod

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