Managing Supply Chain Risks with Derivatives

This paper explores the impact of derivatives on supply chain risks when consumer demand is uncertain. The analysis is based on a simple two-stage supply chain consisting of a single supplier and a single retailer. The retailer can either buy product directly from the supplier, or purchase options on product. An option gives the retailer the right, but not the obligation, to buy an additional unit of product. As such, the retailer will exercise an option if an only if that unit of product is needed to meet demand. The retailer must balance the reduced uncertainty that options afford against the price premium that must be paid to procure product with options. We first derive optimal replenishment policies for the retailer, optimal production policies for the supplier, and closed-form solutions for optimal expected profits. We then show how options enhance information flows, encourage risk sharing, and improve supply chain effciency. The paper includes a discussion of how options can be used to align the incentives of supply chain partners, and to improve supply chain responsiveness to changes in the business environment. We also provide analytical and numerical results that provide insight into how supply chain participants can most effectively utilize options to enhance profitability.