Report Number

2000-009

Abstract

Motivated by a production planning problem in an actual global manufacturing network, we examine the impact of exchange-rate uncertainty ... namely the volatility in and correlations among exchange rates ... on the choice of various optimal production policies and the conditions which lead to them. A two-stage stochastic program with recourse is developed that provides opportunities to hedge financial risk by allowing for some production planning decisions to be deferred until exchange rates are realized. The proposed model and analysis yield the following results: (1) Under significant exchange-rate uncertainty it may be optimal to hedge production by producing less than total demand, (2) production hedging is more likely an optimal policy when either the profit margin is small and/or the exchange rates are highly volatile, (3) the probability of following a production hedging policy decreases as the correlations between exchange rates monotonically increase in a positive direction, (4) after exchange rates are realized it may be optimal to hedge allocation by not allocating all production to some of the markets, and (5) given production and/or allocation hedging, our model identifies the value of financial hedging for each firm rather than a single option price for all firms. This guarantees that all markets are served and that each firm gets an option price that is commensurate with its exchange-rate risk. These findings and implications are illustrated with examples adapted from data provided by IBM.

Date of this Version

1-1-2000

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