Arnd Huchzermeier

Valuing Operational Flexibility Under Exchange Rate Risk

In this paper, we develop a stochastic dynamic programming formulation for the valuation of global manufacturing strategy options with switching costs. Overall, we adopt a hierarchical approach. First, exchange rates are modeled as stochastic diffusion processes that exhibit intercountry correlation. Second, the firms global manufacturing strategy determines options for alternative product designs as well as supply chain network designs. Product options introduce international supply flexibility. Supply chain network options determine the firms manufacturing flexibility through production capacity and supply chain network linkages. Third, switching costs determine the cost of operational hedging, i.e., the costs associated with reducing downside risks. Overall, the firm maximizes its expected, discounted, global, after-tax value through the exercise of product and supply chain network options and/or through exploitation of operational flexibility contingent on exchange rate realizations. In this environment, the firm must trade off fixed operating costs, switching costs, and the economic benefits derived from exploiting differentials in factor costs and corporate tax rates. A multinomial approximation of correlated exchange rate processes is proposed that leads to a consistent and tractable lattice model for this compound option valuation problem. We then demonstrate how the global manufacturing strategy planning model framework can be utilized to analyze financial and operational hedging strategies.

The valuation of options on capacity with cost and demand uncertainty

Abstract Options contracts can provide trading partners with enhanced flexibility to respond to uncertain market conditions and allow for superior capacity planning thanks to early information on future demand. We develop an analytical framework to value options on capacity for production of non-storable goods or dated services. The market consists of a sequence of contract and spot market. Reservations are made during the contract market session in period 0, where the buyer’s future demand, the seller’s future marginal costs as well as the future spot price are uncertain, the latter being impacted neither by the buyer nor the seller. During the spot market session in period 1, the buyer may execute his options or satisfy his entire or additional demand from a competing seller in the spot market. The seller allocates reserved capacity now being called and attempts to sell remaining capacity into the spot market. Analytical expressions for the buyer’s optimal reservation quantity and the seller’s tariff are derived, making explicit the risk-sharing benefits of options contracts. The combination of an options contract and a spot market is demonstrated to be Pareto improving as compared to alternative market schemes. An analysis of the determinants of the efficiency gain characterizes industries particularly suitable to the options approach.

Global Supply Chain Management: A Survey of Research and Applications

Today’s global economic environment is in a state of transition. The principal changes include: 1) worldwide reduction of trade barriers and development of regional, multi-country economic zones, 2) converging consumer expectations for increased product value, variety and availability in all markets, 3) financial obligations to meet new standards for product safety, environmental protection and product recycling that are being adopted internationally, and 4) increased volatility in financial/currency markets. These developments coincide with the adoption of a new competitive strategy by leading multinational companies. This strategy is one of global supply chain management based on enhanced integration of suppliers and customers as well as increased coordination across multiple value-adding processes within the firm (MacCormack et al., 1994; Ohmae, 1995). Such strategies require firms to maintain core competency on a global scale for fundamental processes such as order fulfillment, supply management and new product development, (Majchrzak and Wang, 1995; Womack and Jones, 1996). The global supply chain strategy also requires that the flow of information, cash and material be managed on an international basis, (Porter, 1996; Preiss et al., 1996). As a consequence, the global supply chain strategy involves both operational and financial decisions. Its successful implementation can lead to more effective risk management and the leveraging of both firm-specific and location-specific advantages to yield lower costs and higher revenues.

Strategic Investment Under Uncertainty: A Synthesis

Investment is a central theme in economics, finance, and operational research. Traditionally, the focus of analysis has been either on assessing the value of flexibility (investment under uncertainty) or on describing commitment effects in competitive settings (industrial organization). Research contributions addressing the intersection of investment under uncertainty and industrial organization have become numerous in recent years. In this paper, we provide an overview aimed at categorizing and relating these research streams. We highlight managerial insights concerning the nature of competitive advantage (first- versus second-mover advantage), the manner in which information is revealed, firm heterogeneity, capital increment size, and the number of competing firms.

Risk hedging via options contracts for physical delivery

Abstract. We develop an analytical framework for the valuation of options contracts for physical delivery that enable risk-sharing between the trading partners. The spot market price risk, the buyers demand risk and the sellers marginal cost risk, which are key to many industrial settings such as the chemical industry, are explicitly incorporated. Analytical expressions for the buyers optimal reservation quantity and the sellers optimal tariff are derived and related to the risk management needs in the industry. The ensuing discussion shows how contingency contracts for physical delivery can complement financial derivative instruments within a companys risk management approach.

Ensuring responsive capacity: How to contract with backup suppliers

Firms that source from offshore plants frequently perceive the lack of reliability and flexibility to be among the major drawbacks of their strategy. To mitigate against imminent mismatches of uncertain supply and demand, establishing capacity hedges in the form of responsive backup suppliers is a way out that many firms follow. This article analyzes how firms should contract with backup suppliers, inducing the latter to install responsive capacity. We show that supply options are appropriate to achieve sourcing channel coordination under forced compliance, whereas any firm commitment contract imposes a deadweight loss on the system. Whereas price-only contracts are unable to coordinate the sourcing channel under voluntary compliance, utilization-dependent price-only contracts are. Under the former contract, a price-focused strategy on the part of the manufacturer turns out to diminish the systems service level and possibly has negative implications on installed backup capacity, and not least on the manufacturers profit.

Concurrent Engineering and Design Oscillations in Complex Engineering Projects

Coordination among many interdependent actors is key activity in complex product development projects. The challenge is made more difficult in concurrent engineering processes, as more activities happen in parallel and interact. This coordination becomes progressively more difficult with project size. We do not yet sufficiently understand whether this effect can be controlled with frequent and rich communication among project members, or whether it is inevitable. Recent work in complexity theory suggests that a project might form a “rugged landscape”, for which performance deterioration with system size is inevitable. This article builds a mathematical model of a complex concurrent design project. The model explicitly represents local component decisions, as well as component interactions in determining system performance. The model shows, first, how a rugged performance landscape arises from simple components with single-peaked performance functions, if the components are interdependent. Second, we characterize the dynamic behavior of the system analytically and with simulations. We show under which circumstances it exhibits performance oscillations or divergence to design solutions with low performance. Third, we derive classes of managerial actions available to improve performance dynamics, such as limiting the “effective” system size of fully interdependent components, modularity, and cooperation among designers. We also show how “satisficing”, or a willingness to forego the last few percent of optimization at the component level, may yield a disproportionally large improvement in the design completion time.

Optimizing Rhenania's Mail-Order Business Through Dynamic Multilevel Modeling (DMLM)

Rhenania, a German direct mail-order company, turned its catalog mailing practices around within one year and consequently moved up in market position from number 5 to number 2. A dynamic multilevel modeling (DMLM) approach uses elasticities to determine the optimal frequency of catalog mailings, a customer-segmentation approach allows for optimization of mailings, and a recency, frequency, monetary-value (RFM) segmentation in combination with a chi-square automatic interaction detection (CHAID) algorithm determines when customers should receive a reactivation package--as opposed to a catalog--to optimize mailing efficiency further. The DMLM approach was so effective that Rhenania acquired two competitors (one a subdivision of Springer Verlag).

An Options Approach to Enhance Economic Efficiency in a Dyadic Supply Chain

In this article we present a framework to analyze the efficiency-enhancing impact of contingency contracts. At the beginning of the contract, market session in period 0, the seller announces a two-part tariff applicable to obtaining options on slots of his capacity. This entitles the buyer to a non-storable good or dated service provided by the seller. The buyer in turn decides how many options to purchase. Both parties act under state-contingent uncertainty concerning demand, costs, and spot price. In the spot market in period 1, with uncertainty resolved, the buyer determines his optimal contract and spot consumption portfolio, while the seller offers potentially remaining capacity at the prevailing spot market price. The opportunity of long-term capacity trading and planning provides the seller with an instrument of efficient cost management resulting in lower marginal cost related to long-term capacity allocation as opposed to those associated with allocation on short-notice. Economic efficiency is enhanced in the options scenario as compared to the one obtained in a pure spot market.

The Supply Chain Impact of Smart Customers in a Promotional Environment

Increasing product variety through the use of alternate package sizes is a commonly observed mechanism in the grocery industry. Under such a scheme, however, the response to pricing decisions for each of the different package sizes is affected by how customers make demand choices. We build a demand model in which customers reactsmart to retail promotions through stockpiling and package size switching. The demand model combines a customer choice model with a model in which customers differ in their stockpiling and reservation price levels. We utilize data from the German grocery industry for an empirical fitting of the model. We then develop a store-level inventory model for each SKU and optimize price promotions to maximize expected profit. We show the benefit of capturing thesmart customer response to price promotions by demonstrating its impact on the reduced inventory costs. We use the model to generate a number of managerial implications of the model for the German grocery environment.