Mean-variance newsvendor model with random supply and financial hedging

Abstract

In this paper, we follow a mean-variance (MV) approach to the newsvendor model. Unlike the risk-neutral newsvendor that is mostly adopted in the literature, the MV newsvendor considers the risks in demand as well as supply. We further consider the case where the randomness in demand and supply is correlated with the financial markets. The MV newsvendor hedges demand and supply risks by investing in a portfolio composed of various financial instruments. The problem therefore includes both the determination of the optimal ordering policy and the selection of the optimal portfolio. Our aim is to maximize the hedged MV objective function. We provide explicit characterizations on the structure of the optimal policy. We also present numerical examples to illustrate the effects of risk-aversion on the optimal order quantity and the effects of financial hedging on risk reduction.