Optimal hedging in the presence of internal flexibility

Abstract

Internal flexibility aids in risk management and has a broader application than hedging instruments. This paper demonstrates how optimal hedging policies are affected by it. We develop a dynamic risk management model to capture financial and operational decisions. We first show that internal flexibility reduces the marginal value of hedging instruments. As a result, optimal financial hedging is selective and dependent on investment opportunities. These opportunities account for the majority of the difference between hedged and unhedged firms. By incorporating internal flexibility, the model becomes more realistic but also generates a complex interaction between financial hedging and marketing strategy. During the growth phase, hedging instruments are partially substitutive but have a synergistic effect on investment. In the mature or declining phase, the remedial effect of marketing strategy maintains investment, thereby increasing operating risk and the marginal value of financial hedging. These results are applicable to firms free of agency conflicts and provide a solid theoretical basis for future empirical tests. We advise that scholars thoroughly examine internal flexibility and development stages in the process.