Operational Flexibility and Financial Hedging: Complements or Substitutes
Management Science 2010 INFORMS, Vol. 56, No. 6, June 2010, pp. 1030–1045
16 Pages Posted: 8 Jun 2016
Date Written: June 1, 2010
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
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