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.
We show that production hedging can also reduce risk. This is demonstrated by former doctoral student and now a colleague in the profession, Dr, John Park in another publication (see Park, Kazaz, Webster, Production and Operations Management, 2017). In sum, production hedging is not only a profit-maximizing global operations strategy, but it also mitigates currency risk substantially.
In another publication, we show that production hedging can lead to reduced prices in global markets. Lower prices stimulate demand in various markets enabling the firm to benefit further from the flexibility to allocate to markets with appreciating currencies. As a result, we show that a rational and profit-minded firm can actually lower prices below its manufacturing costs. This is often referred to as dumping in international markets and predatory pricing in local markets. However, we show in another publication (see Park, Kazaz, Webster, Production and Operations Management, 2016) that not all pricing below cost actions should be classified as illegal acts, because a rational and profit-minded firm can price below cost under production hedging even while operating under the exchange-rate risk.