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Risk Aversion in Inventory Management

Author

Listed:
  • Xin Chen

    () (Department of Industrial and Enterprise Systems Engineering, University of Illinois at Urbana--Champaign, Urbana, Illinois 61801)

  • Melvyn Sim

    () (Singapore-MIT Alliance and NUS Business School, National University of Singapore, Singapore)

  • David Simchi-Levi

    () (Department of Civil and Environmental Engineering and Engineering System Division, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139)

  • Peng Sun

    () (Fuqua School of Business, Duke University, Durham, North Carolina 27708)

Abstract

Traditional inventory models focus on risk-neutral decision makers, i.e., characterizing replenishment strategies that maximize expected total profit, or equivalently, minimize expected total cost over a planning horizon. In this paper, we propose a framework for incorporating risk aversion in multiperiod inventory models as well as multiperiod models that coordinate inventory and pricing strategies. We show that the structure of the optimal policy for a decision maker with exponential utility functions is almost identical to the structure of the optimal risk-neutral inventory (and pricing) policies. These structural results are extended to models in which the decision maker has access to a (partially) complete financial market and can hedge its operational risk through trading financial securities. Computational results demonstrate that the optimal policy is relatively insensitive to small changes in the decision-maker's level of risk aversion.

Suggested Citation

  • Xin Chen & Melvyn Sim & David Simchi-Levi & Peng Sun, 2007. "Risk Aversion in Inventory Management," Operations Research, INFORMS, vol. 55(5), pages 828-842, October.
  • Handle: RePEc:inm:oropre:v:55:y:2007:i:5:p:828-842
    DOI: 10.1287/opre.1070.0429
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    File URL: http://dx.doi.org/10.1287/opre.1070.0429
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    References listed on IDEAS

    as
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