Capacity reservation and sourcing under exchange‐rate uncertainty

Abstract

AbstractWe study a firm's capacity reservation and sourcing decisions under exchange‐rate and demand uncertainty. The firm initially reserves capacity from one domestic and one international supplier in the presence of exchange‐rate and demand uncertainty. After observing exchange rates, the firm determines the amount of capacity to utilize for sourcing under demand uncertainty. The article makes four contributions. First, it identifies the set of optimal capacity reservation policies for sourcing activities: One onshore, two offshore, and two dual sourcing policies. The first dual sourcing policy is a defensive action where the firm rations limited capacity between the two sources. The second dual sourcing policy is an opportunistic approach as it features excess capacity investment in order to benefit from currency fluctuations. The analysis shows how the optimal sourcing policy changes with increasing degrees of exchange‐rate volatility. Second, while earlier publications classify cost as an order qualifier, we find that characterization of a dominant sourcing strategy is more nuanced under exchange rate uncertainty. In particular, a buyer might not reserve capacity at a supplier who has a lower (expected) cost and choose to work only with a supplier who has a higher unit expected cost. Third, the article shows that risk aversion reduces the likelihood of single sourcing, specifically offshore sourcing, and increases the likelihood of dual sourcing. Fourth, the study demonstrates that financial hedging can eliminate the negative consequences of risk aversion and make the policy findings more pronounced.