Procurement management using option contracts: Random spot price and the portfolio effect

  • Fu Q
  • Lee C
  • Teo C
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Abstract

This Paper considers the value of portfolio procurement in a supply chain, where a buyer can either procure parts for future demand from sellers using fixed price contracts or, option contracts or tap into the market for spot purchases. A single-period portfolio procurement problem when both the product demand and the spot price are random (and possibly correlated) is examined and the optimal portfolio procurement strategy for the buyer is constructed. A shortest-monotone path algorithm is provided for the general problem to obtain the optimal procurement solution and the resulting expected minimum procurement cost. In the event that demand and spot price are independent, the solution algorithm simplifies considerably. More interestingly, the optimal procurement cost function in this case has an intuitive geometrical interpretation that facilitates managerial insights. The portfolio effect, i.e., the benefit of portfolio contract procurement over a single contract procurement is also studied. Finally, a...

Author-supplied keywords

  • Stochastic programming
  • optimization
  • procurement management

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Authors

  • Qi Fu

  • Chung Yee Lee

  • Chung Piaw Teo

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