Using put option contracts in supply chains to manage demand and supply uncertainty

Abstract

PurposeThe purpose of this paper is to value put 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.Design/methodology/approachThis paper adopts stochastic inventory theory, game theory, optimization theory and algorithm and MATLAB numerical simulation to investigate the manufacturer’s ordering and the supplier’s production strategies, and to study the coordination and optimization strategies in the context of random yield and demand.FindingsThe authors find that put options can not only facilitate the manufacturer’s order but also the supplier’s production, that is, the manufacturer and the supplier can effectively manage their involved risks and earn more expected profits by adopting put options. Further, the authors find that the single put option contract fails to coordinate such a supply chain. However, when combined with a protocol, it is able to coordinate the supply chain.Originality/valueThis paper is the first effort to study the intersection of put option contracts and random yield in the presence of a spot market. From a new perspective, the authors explore the supply chain coordination. The authors propose a mechanism to coordinate the supply chain under put option contracts.