Newsvendor model with random supply and financial hedging: Utility-based approach

Abstract

This paper takes a utility-based approach to the single-period and single-item newsvendor model. Unlike most models in the literature the newsvendor is not necessarily risk-neutral and chooses the order quantity that maximizes the expected utility of the cash flow at the end of the period. We suppose that there is uncertainty in demand as well as supply. Furthermore, random demand and supply may be correlated with the financial markets. The newsvendor exploits this correlation and manages 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 first use a minimum-variance approach to select the portfolio. The analysis results in some interesting and explicit characterizations on the structure of the optimal policy. We also present numerical examples to illustrate the effects of the parameters on the optimal order quantity, and the importance of financial hedging on risk reduction.