Operational Flexibility and Financial Hedging: Complements or Substitutes?

Jiri Chod (), Nils Rudi () and Jan A. Van Mieghem ()
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Jiri Chod: Carroll School of Management, Boston College, Chestnut Hill, Massachusetts 02467
Nils Rudi: INSEAD, 77305 Fontainebleau, France
Jan A. Van Mieghem: Kellogg School of Management, Northwestern University, Evanston, Illinois 60208

Management Science, 2010, vol. 56, issue 6, 1030-1045

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 (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (54)

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