Operational Flexibility and Financial Hedging: Complements or Substitutes?, Management Science
We consider a risk-sensitive 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. While 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. Our results rely in part on analytical proofs and in part on numerical analysis.
Jiri Chod, Nils Rudi, Jan A. Van Mieghem
Chod, Jiri, Nils Rudi, and Jan A. Van Mieghem. 2010. Operational Flexibility and Financial Hedging: Complements or Substitutes?. Management Science. 56(6): 1030-1045.