Multisources Risk Management in a Supply Chain under Option Contracts

Abstract

Uncertainties in product demand, component yield, and spot price are keys to many industrial settings and they are usually explicitly incorporated. This paper develops an analytical framework to value option contracts in hedging the risks in a supply chain consisting of a component supplier with random yield and a manufacturer facing stochastic demand for end products. The manufacturer can obtain the components from the supplier through firm order contracts and option contracts. Apart from the contract market, there is a spot market in which both the manufacturer and the supplier can buy or sell the components. Analytical expressions for the optimal ordering and production policies are derived. Our study shows that the manufacturer and the supplier can effectively deal with the risks they involve by adopting option contracts. However, we find that the supply chain cannot be coordinated by the traditional option contract. To coordinate such system, we propose a protocol to be combined with the option contract. Finally, the explicit condition for coordination under the proposed contracts is identified.