Supporting Operations with Financial Hedging: Cash Hedging Versus 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 test two data-driven hedging policies to see how effective they are 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 widely in use. 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. The firm solves a stochastic program with a min hedge cost objective and cash flow constraints to construct the cash hedge. Its solution suggests that the firm needs to trade S&P500, aluminum, and zinc to implement the hedge. Our results further reveal the relative importance of different market factors on the automaker’s hedging policy. 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.