Financial Hedging Decision on Procurement Risk for Newsvendor Model with Value-at-Risk Constraint

• Main Authors: WEN, Yuan, DING, Qing, CHEN, Jian
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2011
• Subjects: Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/3119; https://ink.library.smu.edu.sg/context/lkcsb_research/article/4118/viewcontent/20430_Financial_Hedging_Decisions_on_Procureme.pdf
• Institution: Singapore Management University

Manufacturers must now deal with increasingly fluctuating procurement prices for commodities and industrial component parts. However, it is hard for them to pass cost increases on to downstream markets efficiently. Therefore, manufacturers have sought to solve this problem with various supply management tactics. While vertical integration of key suppliers or signing long-term contracts is possible, financial hedging emerges as the most effective approach to counter commodities price risks. In situations where market demand uncertainty is still unresolved and often interplays with upstream price volatilities, Value-at-Risk (VaR) can help managers handle the multi-fold uncertainties and their potential interactions, by effectively measuring risk. Its usefulness has led it to become a standard adopted by Basel Accord II and III. In this paper, VaR is employed to capture downside risk a version as a constraint imposed on the objective of expected profit maximization, i.e. the probability that the profit less than a reserved profit level does not exceed a risk level. Based on the above scenario, some questions that naturally arise include: 1) What is the optimal financial hedging policy and thereafter the optimal order quantity? 2) How do the optimal decisions depend on the firm’s risk aversion, price and demand uncertainty, and their correlation? 3) What is the value of financial hedging? Two papers are closely related to ours. Chen and Yano (2010) study a seasonal product supply chain, using VaR constraint to capture risk aversion. As the product demand correlates with weather conditions, the manufacturer offers a weather-linked rebate contract that coordinates the channel. The manufacturer can further offset the weather risk transferred from the retailer by buying weather options. Compared with them, we consider a newsvendor problem in a spot market. The firm faces uncertainties of procurement price in addition to market demand. Also, the hedging decision is a portfolio contingent on the procurement price with completed term and strike structure. Oum and Oren (2009) study the hedging decision for a load-serving entity in the electricity market with price and quantity risks. The objective of maximizing expected hedged profit is subject to a VaR constraint. It proposes an approximation method to solve the problem. We, on the other hand, consider joint hedging and ordering decisions for the newsvendor problem, and give the optimal solutions in an explicit form.