BFS 2002

Contributed Talk

Option Contracts in Supply Chains

Apostolos Burnetas, Peter Ritchken

This article investigates the role of option contracts in a supply chain when the demand curve is downward sloping. We consider call (put) options that provide the retailer with the right to reorder (return) goods at a fixed price. We show that the introduction of options causes the wholesale price to increase and the volatility of retail price to decrease. In general, options are not zero sum games. Conditions are derived under which the manufacturer prefers to use options. When this happens the retailer may also benefit or be worse off. Specifically, if the uncertainty in the demand curve is high, the introduction of options alters the equilibrium prices in a way that hurts the retailer. Finally, we demonstrate that if either the manufacturer or the retailer wants to hedge the risk, contracts that pay out according to the square of the price of a traded security are required.