Managing Supply Risk in Fixed Price Contracts: A Contingent Claims Perspective

Abstract

The primary focus of this paper is supply risk mitigation. though, its objectives are twofold. First, we develop a generic contingent claims model framed as an exercise in stochastic optimal control. The model is easily adjusted to a number of risk-based operational problems. Second, we adapt the model to the problem of supply uncertainty and the valuation of a fixed price contract with a focus on managing supply uncertainty through a portfolio based risk sharing framework. The risk and reward tradeoffs characterizing our general findings in this chapter indicate a subtle balance between supply risk, sourcing allocations and related costs, and accordingly, the resulting operational strategies considered. Given this setup, increased supplier-portfolio risk is a defining measure in establishing optimal operating policies, with the caveat that increases in the supplier portfolio’s volatility, also increase shortages which lowers the contract’s value.