Risk Aversion in Inventory Management

Authors:
Xin Chen;Melvyn Sim;David Simchi-Levi;Peng Sun
Affiliations:
Department of Industrial and Enterprise Systems Engineering, University of Illinois at Urbana--Champaign, Urbana, Illinois 61801;Singapore-MIT Alliance and NUS Business School, National University of Singapore, Singapore;Department of Civil and Environmental Engineering and Engineering System Division, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139;Fuqua School of Business, Duke University, Durham, North Carolina 27708
Venue:
Operations Research
Year:
2007

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Abstract

Traditional inventory models focus on risk-neutral decision makers, i.e., characterizing replenishment strategies that maximize expected total profit, or equivalently, minimize expected total cost over a planning horizon. In this paper, we propose a framework for incorporating risk aversion in multiperiod inventory models as well as multiperiod models that coordinate inventory and pricing strategies. We show that the structure of the optimal policy for a decision maker with exponential utility functions is almost identical to the structure of the optimal risk-neutral inventory (and pricing) policies. These structural results are extended to models in which the decision maker has access to a (partially) complete financial market and can hedge its operational risk through trading financial securities. Computational results demonstrate that the optimal policy is relatively insensitive to small changes in the decision-maker's level of risk aversion.