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Input-Price Risk Management: Technology Improvement and Financial Hedging

37 Pages Posted: 25 Sep 2017 Last revised: 9 Feb 2018

Ali Shantia

HEC Paris - Operations Management and Information Technology; LUISS Guido Carli University - Department of Business and Management

Sam Aflaki

HEC Paris - Operations Management and Information Technology

Hamed Ghoddusi

Stevens Institute of Technology - School of Business

Date Written: September 21, 2017

Abstract

Research has suggested that firms may benefit from price uncertainty - about input commodities - because it creates an "option value". We use a stylized mathematical model to explore and generalize this claim and to specify its implications for firms' investment decisions under various setups. In particular, we study firms' motivation for investing in such risk management measures as financial hedging (FH) and technology improvement (TI): technology changes that result in less consumption of an input commodity, fewer waste products and emissions, and lower production costs. We derive a simple expression that explicitly quantities firm's attitude toward input-price risk by considering the firm's (positive or negative) risk premium (i.e., what it would pay to "lock in" the unit input price at its mean) and linking that premium to various firm and industry-level characteristics. Also, we examine the comparative risk management advantages of TI and FH and characterize conditions under which these strategies are complements or substitutes. We find that although input-price uncertainty may be beneficial even for risk-averse firms, they can benefit from investing in risk reduction measures (e.g., TI, FH) because they could increase the option value of that uncertainty. A firm's ability to adjust its price in response to both market competition and input-price variation mediates the benefit of risk-reducing measures and also affects the two strategies' complementarity.

Keywords: Risk Management, Risk Exposure, Technology Improvement, Financial Hedging

Suggested Citation

Shantia, Ali and Aflaki, Sam and Ghoddusi, Hamed, Input-Price Risk Management: Technology Improvement and Financial Hedging (September 21, 2017). HEC Paris Research Paper No. MOSI-2017-1231; Stevens Institute of Technology School of Business Research Paper. Available at SSRN: https://ssrn.com/abstract=3041440 or http://dx.doi.org/10.2139/ssrn.3041440

Ali Shantia (Contact Author)

HEC Paris - Operations Management and Information Technology ( email )

1, rue de la Liberation
Jouy en Josas, 78351
France

LUISS Guido Carli University - Department of Business and Management ( email )

Via Salvini, 3
Rome, 00198
Italy

Sam Aflaki

HEC Paris - Operations Management and Information Technology ( email )

1, rue de la Liberation
Jouy en Josas, 78351
France

Hamed Ghoddusi

Stevens Institute of Technology - School of Business ( email )

Hoboken, NJ 07030
United States

HOME PAGE: http://www.ghoddusi.com

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