“risk Sharing and Supplier Switching Contracts” Bardia Kamrad

Using a real options framework, we value and analyze supply contracts characterized by exchange rate uncertainty, order quantity flexibility and supplier-switching options. Analogous to the portfolio optimization framework, our framework analyzes the incentives that the suppliers face in accepting order level flexibility. The resulting tradeoff (for the supplier) is a balance between greater volatility in the supply schedule and the prices that the producer pays. In this context, we explicitly model how flexibility can be beneficial to both the producer and multiple suppliers. In other words, how a contract with quantity flexibility can be Pareto optimal, with neither the producer nor the suppliers being worse off as compared to inflexible contracts. This implies that option to switch between suppliers is not costless, thus resulting in the producer having to compensate suppliers in a manner consistent with a profit maximization objective for all parties.