Integrated Contract and Spot Market Procurement by a Risk-Averse Buying Firm

Abstract

We study the problem of optimally integrating contractual and spot market procurement sources for a risk-averse buying firm that purchases a commodity product at a specified rate over time. The sources involve deterministic and stochastic price processes, respectively. The risk-averse firm is concerned about the magnitude and uncertainty of procurement expenses. The problem is of increasing significance with the emergence of electronic markets that facilitate procurement from competitive spot (open) market. Models are developed to determine the optimal procurement policy in continuous time across the two sources for specified price and risk aversion parameters. We examine cases when the contract price parameter is exogenously specified and when it is endogenously adjusted according to the procurement policy. We show that the optimal strategy prescribes simultaneous procurement from both contract and spot market sources. The applications of the model on illustrative datasets provide insights into the relative advantages of integrating the two sources of procurement over a “pure contract” or a “pure market” procurement source.