Input-Price Risk Management: Technology Improvement and Financial Hedging

Research has suggested that firms may benefit from price uncertainty - about input commodities - because it creates an "option value". We use a stylized mathematical model to explore and generalize this claim and to specify its implications for firms' investment decisions under various setups. In particular, we study firms' motivation for investing in such risk management measures as financial hedging (FH) and technology improvement (TI): technology changes that result in less consumption of an input commodity, fewer waste products and emissions, and lower production costs. We derive a simple expression that explicitly quantities firm's attitude toward input-price risk by considering the firm's (positive or negative) risk premium (i.e., what it would pay to "lock in" the unit input price at its mean) and linking that premium to various firm and industry-level characteristics. Also, we examine the comparative risk management advantages of TI and FH and characterize conditions under which these strategies are complements or substitutes. We find that although input-price uncertainty may be beneficial even for risk-averse firms, they can benefit from investing in risk reduction measures (e.g., TI, FH) because they could increase the option value of that uncertainty. A firm's ability to adjust its price in response to both market competition and input-price variation mediates the benefit of risk-reducing measures and also affects the two strategies' complementarity.