DP9266 How to use demand systems to evaluate risky projects, with an application to automobile production

Author(s): Richard Friberg, Cristian Huse
Publication Date: December 2012
Keyword(s): demand estimation, Exchange rate exposure, operational hedging, risk management
JEL(s): F23, L16, L62
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=9266

This article introduces a method to quantify the effect of a firm’s strategic choices on the risk profile of its profits at different horizons. We combine a demand system for differentiated products with counterfactual paths of risk factors. Prices, costs and quantities respond endogenously to the counterfactual state of the world. The draws on risk factors are generated using copulas, in a way that flexibly can be adapted to the risks faced in various industries. We illustrate the method by studying how the US operations of German carmakers BMW and Porsche are affected by the decision to relocate production, i.e. operational hedging. We find that for plausible costs of building a plant, production in the US is attractive for BMW, but not for Porsche.