The impact of alternative performance measures on portfolio procurement with contingent option contracts

Abstract

This paper studies a single period procurement problem, in which a buyer procures using a set of contingent option contracts as well as the random spot market to meet the uncertain demand. For the contingent option contracts, the buyer can pay a unit reservation price for the right to buy a unit of product in the future at a discount rate of the market price. We analyze the portfolio procurement strategy in this setting, with both risk-neutral objective and risk measure of Conditional Value-at-Risk (CVaR) of the procurement cost. In the risk-neutral case, we show that the problem can be solved using a simple line search method. While for the CVaR objective, it is a difficult planning problem as the objective function involves multiplication of two random parameters, demand and spot price. Thus, we use the elegant solution approach for the risk-neutral problem to propose a simple heuristic for the risk-adjusted procurement problem with CVaR objective. Computational experiments show that our proposed heuristic works well in controlling risk exposure, while sacrificing slightly on the expected procurement cost. We also conduct numerical experiments to compare the solution and performance of these two alternative planning approaches and discuss the managerial insights.