Operational Flexibility and Financial Hedging: Complements or Substitutes

Abstract

We consider a firm that invests in capacity under demand uncertainty and thus faces two related but distinct types of risk: mismatch between capacity and demand and profit variability. Whereas mismatch risk can be mitigated with greater operational flexibility, profit variability can be reduced through financial hedging. We show that the relationship between these two risk mitigating strategies depends on the type of flexibility: Product flexibility and financial hedging tend to be complements (substitutes) — i.e., product flexibility tends to increase (decrease) the value of financial hedging, and, vice versa, financial hedging tends to increase (decrease) the value of product flexibility — when product demands are positively (negatively) correlated. In contrast to product flexibility, postponement flexibility is a substitute to financial hedging as intuitively expected. Although our analytical results assume perfect flexibility and perfect hedging and rely on a linear approximation of the value of hedging, we validate their robustness in an extensive numerical study.

Keywords: financial hedging; postponement; flexibility; risk management