Hedging demand and supply risks in the newsvendor model

We consider a single-period inventory model where there are risks associated with the uncertainty in demand as well as supply. Furthermore, the randomness in demand and supply is correlated with the financial markets. Recent literature provides ample evidence on this issue. The inventory manager may then exploit this correlation and manage his risks by investing in a portfolio of financial instruments. The decision problem, therefore, includes not only the determination of the optimal ordering policy, but also the selection of the optimal portfolio at the same time. We analyze this problem in detail and provide a risk-sensitive approach to inventory management where one considers both the mean and the variance of the resulting cash flow. The analysis results in some interesting and explicit characterizations on the structure of the optimal policy.

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