The Interaction of Technology Choice and Financial Risk Management: An Integrated Risk Management Perspective

Abstract

This paper analyzes the integrated operational and financial risk management portfolio of a firm that determines whether to use flexible or dedicated technology and whether to undertake financial risk management or not. The risk management value of flexible technology is due to its risk pooling benefit under demand uncertainty. The financial risk management motivation comes from the existence of deadweight costs of external financing due to capital market imperfections. Financial risk management has a fixed cost, while technology investment incurs both fixed and variable costs. The firm's limited budget, which depends partly on a tradable asset, can be increased by borrowing from external markets, and its distribution can be altered with financial risk management. In a parsimonious model, we solve for the optimal risk management portfolio, and the related capacity, production, financial risk management and external borrowing levels, the majority of them in closed form. We characterize the optimal risk management portfolio as a function of firm size, technology and financial risk management costs, product market (demand variability and correlation) and capital market (external financing costs) characteristics. Our analysis contributes to the integrated risk management literature by characterizing the optimal risk management portfolio in terms of a more general set of operational and financial factors; providing the value and limitation of operational and financial risk management by explicitly modeling their costs and benefits; demonstrating the interactions between the two risk management strategies; and relating our theoretical results to empirical observations.