Coordination and Flexibility in Supply Contracts with Options

We investigate the role of options (contingent claims) in a buyer-supplier system. Specifically using a two-period model with correlated demand, we illustrate how options provide flexibility to a buyer to respond to market changes in the second period. We also study the implications of such arrangements between a buyer and a supplier for coordination of the channel. We show that, in general, channel coordination can be achieved only if we allow the exercise price to be piecewise linear. We develop sufficient conditions on the cost parameters such that linear prices coordinate the channel. We derive the appropriate prices for channel coordination which, however, violate the individual rationality constraint for the supplier. Contrary to popular belief (based on simpler models) we show that credit for returns offered by the supplier do not always coordinate the channel and alleviate the individual rationality constraint. They are are useful only on a subset of the feasibility region under which channel coordination is achievable with linear prices. Finally, we demonstrate (numerically) the benefits of options in improving channel performance and evaluate the magnitude of loss due to lack of coordination. March 11, 2002 Supply Contracts with Options