Strategic Risk Management in Spot Market for Supply Chains Under Competition

Abstract

This paper studies two risk management strategies related to spot market to mitigate demand uncertainty: operational hedging and financial hedging. Consider a supplier selling an intermediate good to two manufacturers, who use it to produce a final product and compete with each other in the final product market. The manufacturer can reduce the supply and demand mismatch risk by operational hedging through sourcing in the spot market, or reduce the profit variability by financial hedging. We find that the supplier charges a lower contract price when selling to operational hedger(s), which hurts the supplier. However, the operational hedger may not benefit from the lower contract price when competing with a financial hedger. By opting out of spot trading and making a commitment to the final production output, the financial hedger benefits from competing with an operational hedger, who is forced to reduce his procurement quantity and final output to avoid intense competition when the former commits a large output. Furthermore, the profit variation of the financial hedger is reduced by a larger percentage when competing with an operational hedger. As a result, both firms may incline to adopt financial hedging instead of operational hedging, leading to a situation of the Prisoner's Dilemma.