Operational Flexibility and Financial Hedging: Complements or Substitutes?

Abstract

W e 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.

A Little Flexibility Is All You Need: On the Asymptotic Value of Flexible Capacity in Parallel Queuing Systems

“…And how much flexibility is needed to effectively match demand and supply? The extant literature on flexibility refers to the ability of a resource to process multiple types of products as mix- (Chod et al 2010), process- (Sethi and Sethi 1990), product- (Fine and Freund 1990) or scope-flexibility (Van Mieghem 2008). Substantial progress has been made in our understanding of flexibility over the last 20 years.…”

Introduction to the Special Issue on Research at the Interface of Finance, Operations, and Risk Management (iFORM): Recent Contributions and Future Directions

“…Interesting work looks into the complementarity/substitution aspects of financial hedges and operational risk mitigation strategies (see Chod et al 2010). However, the fundamental question if financial hedging should be used for managing operational risks was left to corporate finance theory insights mostly informed by single firm and financial friction justifications (for an exemplary reference, and reference therein, see Froot et al 1993).…”

Integrated Strategic Planning of Global Production Networks and Financial Hedging under Uncertain Demands and Exchange Rates

“…Nevertheless, this gap in the research literature received a greater amount of attention only recently. Chod, Rudi, and Van Mieghem (2010) investigated the relationship between financial hedging and product flexibility under uncertain demands. They showed that product flexibility and financial hedging can be both complements and substitutes depending on the prevailing demand correlations.…”