Hedging Inventory Risk Through Market Instruments

We address the problem of hedging inventory risk for a short life cycle or seasonal item when its demand is correlated with the price of a financial asset. We show how to construct optimal hedging transactions that minimize the variance of profit and increase the expected utility for a risk-averse decision maker. We show that for a wide range of hedging strategies and utility functions, a risk-averse decision maker orders more inventory when he or she hedges the inventory risk. Our results are useful to both risk-neutral and risk-averse decision makers because (1) the price information of the financial asset is used to determine both the optimal inventory level and the hedge, (2) this enables the decision maker to update the demand forecast and the financial hedge as more information becomes available, and (3) hedging leads to lower risk and higher return on inventory investment. We illustrate these benefits using data from a retailing firm.

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