Operational Hedging and Diversification under Supply and Demand Uncertainty
AbstractWhen facing supply uncertainty caused by exogenous factors such as adverse weather conditions, firms diversify their supply sources following the wisdom of â€œnot holding all eggs in one basketâ€. We study a firm that decides on investment and production levels of two unreliable but substitutable resources. Applying real options thinking, production decisions account for actual supply capabilities whereas investment decisions are made in advance. To model trivariate supply and demand correlation, we adopt the concepts of random capacity and stochastic proportional yield. We identify optimal forms of investment decisions that depend on the resourcesâ€™ reliabilities, capacity costs, and contribution margins. Contrary to financial hedging theory, this paper shows that supply hedges provide substantial value even if supply resources are perfectly positively correlated. Furthermore, when exposure to demand risk increases, it is the backup supplyâ€™s correlation with demand, rather than correlation between supply sources, that matters for investment decisions.
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Bibliographic InfoPaper provided by International Institute of Social Studies of Erasmus University (ISS), The Hague in its series ISS Working Papers - General Series with number ERS-2011-018-LIS.
Date of creation: 31 May 2011
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Web page: http://www.iss.nl/
diversification; capacity management; operational hedging; supply risk correlation; supply risk;
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