In managing global supply chains, one of the major challenges is to prepare for the risks associated with exchange-rate fluctuations. An upswing in conversion rates can make you a successful manager, a downswing can result in the loss of your executive position. Protecting the value of revenues denominated in foreign currency through financial instruments (futures, forward contracts, or currency options) can eat up your profits. So, what are alternative ways to manage exchange-rate fluctuations using supply chain design?
Operational Hedging: One common approach is to build additional capacity in the supply chain in order to capitalize on the exchange-rate movements (see Huchzermeier and Cohen, Operations Research, 1996). The proposed approach suggests that the firm should move its production to countries where the currency is depreciating in order to maximize (expected) profits. While this is beneficial, the firm has to make an expensive capital investment initially.
Production Hedging: In our publication in Management Science (2005), we offer an alternative to the above approach. Rather than investing in capacity through expensive capital outlay upfront, the firm deliberately produces less than its total global demand, and adjusts its allocation/distribution to foreign markets based on the fluctuations in exchange rates. We term this as production hedging as the firm acts conservatively by shorting its production in anticipation of losses that can stem from devalued currency. While producing less than the total demand sounds controversial at first, there are many examples when the firm can make more money under a production hedging policy than a policy that satisfies the global demand. As shown in the publication, this is a robust policy as production hedging exists in many scenarios, under a single-period and a multi-period analysis, under correlated exchange rates, under demand uncertainty, and when the firm is a price-setter.
My doctoral student John Park is extending this work with several interesting results. I will report them here upon the completion of the study.