Risk Mitigation of Production Hedging

This study examines how a firm can mitigate global economic risk through production hedging, defined as producing less than the total demand. We investigate a firm's production planning, pricing, and financial hedging decisions under exchange rate and demand uncertainty with the objective of maximizing expected profit while complying with a value-at-risk (VaR) constraint that limits the firm's losses in amount and probability. The study makes three contributions. First, we show that production hedging, when compared to matching demand with production, can substantially reduce risk both from VaR and conditional-VaR perspectives while increasing expected profit. Our second contribution relates to the optimal pricing decisions. When a firm has pricing flexibility, it is commonly expected that the optimal price would increase under production hedging. Our study, however, shows that production hedging causes the firm to decrease the optimal price below the riskless price in order to benefit from exchange rate fluctuations. The pressure from risk aversion on the optimal price decision is not one directional, and can lead to both an increase and a decrease in price. Third, our work examines the interactions between financial hedging and production hedging. It identifies when financial hedging serves as a complement, and when as a substitute, to production hedging. Our work shows that financial hedging cannot always eliminate production hedging from being an optimal solution.