Report Number

2010-003

Abstract

Purchasing goods from distant locations introduces a significant lag between when a product is shipped and when it arrives. These transit lags are trade barriers for firms facing volatile demand, who must place orders before knowing the resolution of demand uncertainty. We provide a model in which airplanes bring producers and consumers together in time. Fast transport allows firms to respond quickly to favorable demand realizations and to limit the risk of unprofitably large quantities during low demand periods. The model predicts that the likelihood and extent to which firms employ air shipments is increasing in the volatility of demand they face, decreasing in the air premium they must pay, and increasing in the contemporaneous realization of demand. We confirm all three conjectures using detailed US import data. Fast transport thus provides firms with a real option to smooth demand volatility on international markets, and we provide simple calculations of that option value. This enables us to identify how the option value relates to goods characteristics, and to changes in air transport premia associated with technological and policy change including the introduction of jet engines, and liberalization of trade in air services.

Keywords

hedging, volatility, adjustment costs, air transport, real option

Date of this Version

1-1-2010

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