Supporting Operations with Financial Hedging: Cash Hedging Vs. Cost Hedging in an Automotive Industry

Abstract

Financial hedging of raw material prices and exchange rates has become an integral part of many manufacturers' operating practices. Previous empirical research suggests that a desire to avoid financial distress and the affiliated curtailment in operations is one of the strongest hedge motivations. Taking the hedging motivation as given, we examine the effectiveness of two data‐driven hedging policies at mitigating financial distress in the car manufacturing industry. The first policy is the “cost hedging” policy, under which the carmaker hedges raw material and production input purchases. This policy appears to be in wide use in practice. The car manufacturer needs to trade in aluminum, steel, zinc, and plastic to achieve the cost hedge. The second policy is a “cash hedging” policy under which the firm hedges its net cash flow. To determine a cash hedging policy, the firm solves a stochastic program that minimizes its hedge cost subject to cash flow constraints. The program solution suggests that the firm needs to trade S&P500, aluminum, and zinc to implement the hedge. Our results reveal that the most critical drivers of hedging decisions appear to be demand shifts, especially demand elasticity shifts. The least important drivers are car design updates, which change the car's raw material requirements. This finding sheds light on why cost hedging, which focuses on hedging raw materials, is less effective than the cash hedging technique, which hedges both costs and demand.