Publication Type
Working Paper
Version
publishedVersion
Publication Date
6-2025
Abstract
In manufacturing firms, besides demand uncertainty, capacity investment decisions may also be subject to uncertainty in the availability of a production resource (e.g., budget or commodity component) which may become constraining for manufacturing. When the production resource uncertainty is tied to a financial index (e.g., asset or commodity price), the firm can enter into financial hedging contracts at the time of capacity investment to engineer this uncertainty. Our paper characterizes the optimal capacity investment and hedging decisions and examines how production resource uncertainty impacts the firm’s decisions, profitability, and the value of hedging. We identify three key drivers of these impacts: capacity cost, correlation between demand and production resource, and production resource variability. Our analysis shows that full hedging is optimal when capacity cost is high or correlation is low. Otherwise, the firm chooses no hedging if production resource variability is low, and partial hedging if it is high. Under optimal hedging, higher correlation always enhances profitability, while increased production resource variability is never detrimental. In particular, when no hedging is optimal, both optimal capacity and profitability strictly increase with variability. Interestingly, when partial hedging is optimal, the firm increases its hedge as variability rises, fully offsetting the impact—rendering capacity and profitability insensitive to variability. Finally, we find that the value of hedging increases with production resource variability but decreases with correlation. These findings offer valuable managerial insights for firms making capacity investment decisions while managing the fluctuations in production resource availability through financial hedging.
Keywords
capacity investment, demand uncertainty, financial hedging, correlation, production resource uncertainty
Discipline
Corporate Finance | Finance and Financial Management
Research Areas
Operations Management; Finance
First Page
1
Last Page
59
Embargo Period
6-18-2025
Citation
BOYABATLI, Onur and FENG, Guiyun.
Capacity investment in the presence of correlated demand and production resource uncertainties and its implications for financial hedging. (2025). 1-59.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/7723
Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-No Derivative Works 4.0 International License.