Valuing Operational Flexibility Under Exchange Rate Risk

In this paper, we develop a stochastic dynamic programming formulation for the valuation of global manufacturing strategy options with switching costs. Overall, we adopt a hierarchical approach. First, exchange rates are modeled as stochastic diffusion processes that exhibit intercountry correlation. Second, the firm's global manufacturing strategy determines options for alternative product designs as well as supply chain network designs. Product options introduce international supply flexibility. Supply chain network options determine the firm's manufacturing flexibility through production capacity and supply chain network linkages. Third, switching costs determine the cost of operational hedging, i.e., the costs associated with reducing downside risks. Overall, the firm maximizes its expected, discounted, global, after-tax value through the exercise of product and supply chain network options and/or through exploitation of operational flexibility contingent on exchange rate realizations. In this environment, the firm must trade off fixed operating costs, switching costs, and the economic benefits derived from exploiting differentials in factor costs and corporate tax rates. A multinomial approximation of correlated exchange rate processes is proposed that leads to a consistent and tractable lattice model for this compound option valuation problem. We then demonstrate how the global manufacturing strategy planning model framework can be utilized to analyze financial and operational hedging strategies.