The Impact of Options Trading on Supply Chain Management

This paper explores the impact of options on supply chain performance when consumer demand is uncertain. The analysis is based on an environment involving a single supplier and multiple retailers. Each 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 and 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. Unlike other options and option-like contract arrangements that have been studied in the supply chain management literature, the options considered in this paper are independent of any contractual arrangement made between a particular buyer and seller. As such, these instruments can be traded among retailers as more information about the actual demand each faces becomes available, allowing contingency claims to flow to those retailers whose supply needs are greatest. We first derive optimal replenishment policies for the retailers, the optimal production policy 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 efficiency. 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 then consider an open market for trading supply chain derivatives, and characterize how an individual retailer should react to the opportunity to buy and sell options on product. We characterize the equilibrium market price at which options should trade, and demonstrate that this trading increases the expected profits of all retailers. Additional insights into the value of a market for trading supply chain options are derived through numerical exploration.