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Derivatives in Supply Chain Dailun Shi & William Grey IBM T. J. Watson Research Center Richard Daniels University of Georgia Agenda Background and Motivation Research Content Results Future Research Directions Risk Management in The financial Services Industry Portfolio management CAPM VAR for market and credit risk Credit rating/scoring methodologies Options pricing models Derivative products Futures, swaps, options, floors, caps, etc. Operational risk management techniques Risk-adjusted capital allocation Supply Chain Risk Management Research at IBM T. J. Watson Center Supply chain risk profiling Quantifying financial impacts of risks Risk assessment Risk management strategy - design and implementation Operational management Financial management Insurance products Options, Futures, Swaps Derivatives in Supply Chain Is there a need for options to manage supply chain risk? Implications of introducing options into SCM: Behavioral Financial Information sharing Risk sharing Problem Setting and Parameters A single period two-party supply chain: Supplier Retailer End Customers Highly perishable, short-life-cycle product Two replenishment modes: firm orders & options Parameters: D: stochastic demand with pdf f(D) and cdf F(D) W: wholesale price = unit cost of firm order C: unit cost of option, X: option exercise price R: product retail price, M: unit manufacturing cost P: penalty for defaulting on options expediting cost vs. cash penalty The Newsvendor Problem Overage risks of salvaging inventory at loss Price markdowns Inventory holding costs Underage risks of unmet demand Lost profit Cost of expediting Customer ill will Implications for the retailer Order less than in ISC Bear all overage risks Has some underage risks Implications for the supplier Build to order No overage risks Substantial underage risks Feasibility Conditions Following conditions hold among parameters M < W < C+X < R PM X>S Those conditions ensure well-behaved profit functions, thus lead to unique optimal solutions Sequence of Events Background: procurement decisions is made before selling season, with no opportunity to replenish inventory once the season starts Transaction terms (W, C, X, P) are determined At t=0 The retailer places orders Q and q The supplier decides production quantity Y The supplier delivers Q units, holds (Y-Q) inventory During the season t1 The retailer exercises options ( q) The supplier delivers additional units to the retailer The Retailer’s Decisions The retailer has two decision variables: number of firm orders Q and number of options q. Total order quantity T = Q+q The retailer’s expected profit function: Q T 0 Q E (Q, T ) ( X C W )Q ( R X C )T ( R S ) F ( D)dD ( R X ) F ( D)dD The retailer’s optimal order quantities: F (T *) Pr( D T *) R X C RX F (Q*) Pr( D Q*) X C W X S The Supplier’s Decisions Decision variable for the supplier: Y = the number of products to produce, and its range is Q*Y T* The supplier’s expected profit function: E(Y ) (W P)Q * ( X C P)q * ( P M )Y Y T* ( X S ) F ( D)dD ( X P) Q* Y F ( D)dD The unique maximum point of the expected profit function: F (Y * *) Pr( D Y * *) PM PS The supplier’s optimal production quantity Y*: Q*, Y * Y * *, T *, if Y * * Q * if Q* Y * * T * if T * Y * * Results Supply Chain Coordination Risk Sharing Information Sharing Supply Chain Contract Negotiation Supply Chain Coordination Double Marginality Problem Separate ownership of two supply chain parties Neither has control of the entire supply chain Conflicting objectives Asymmetric information about demands Total supply chain profit is (R-M)Q, if Q is produced R W Q* F ( ) Without options, total product quantity: RS RM Integrated supply chain produces: Q F ( R S ) Since M < W, Q * QI* 1 * I 1 Supply Chain Coordination (cont..) Options introduce three more degrees of freedom (X, C and P), in addition to W Conditions for the retailer to coordinate: R X C R M T * Q * q* QI* RX RS Conditions for the supplier to coordinate: PM R X C Y* T * PS RX Risk Sharing Options provide a tool for the retailer to manage demand uncertainty Firm orders for demand relatively sure to sell Options for products less likely to be needed Hedge against both overage and underage risks Pay a premium to purchase options Options also benefit the supplier Inducing the retailer to purchase more products Must hold inventories for options Bottom-line: both parties are better off Risk Sharing (cont.) Profit Increase Profits Improvement from Options 90.0% manufacturer (mean = 3000) 80.0% retailer (mean = 3000) Chain (mean =300) 70.0% manufacturer (mean = 4000) retailer (mean = 4000) 60.0% Chain (mean =4000) 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 0 400 800 1200 1600 demand stdv 2000 Risk Sharing (cont.) Two fundamental issues in supply chan optimization with options: Set transaction parameters to maximize total profits Allocate total profit equitably between the two parties Observations: Coordination conditions ensure profits of ISC Coordination conditions provide no insight into total profit allocation Wholesale price W is not in the coordination conditions W doesn’t effect T* and Y* Varying W is effective for total profit allocation Two potential ways for the profit allocation: Set X, C, P, and W to ensure both parties better off Distribute profit based on “risk-adjusted profit” Information Sharing Fix contract terms (R, W, X, C, P and M), RHS of equations for T*, Q*, Y** are constant, denoting them CT*, CQ*, CY** Assume normal demand with mean µ and stdv σ, we have: Z 1 (C Z ) for Z = T*, Q*, and Y** 1 1 q * (CT * ) (CQ* ) T* / 1 (CT * ) The implied θ in Y* = Q* + θq* is constant w.r.t to µ and σ The above results are also true for non-normal demand Information implications of the 3rd result: The retailer’s (Q*, q*) reveal demand information (µ,σ) completely The supplier always produces fixed percentage for options Supply Chain Contract Negotiation Contract terms and conditions are usually determined by: Relative market power Incentive considerations Promotions Understanding the impacts of contract parameters (R, X, C, W, P) on both parties’ profits is important We have analytic results on related questions The following slides show graphic presentations Impact of Option Cost C on Profits profit Increase 35.0% manufacturer's gain 30.0% retailer's gain supply chain gain 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 10 12 14 16 18 20 22 24 Option Cost C -5.0% -10.0% 26 28 Profit Increase Impact of Exercise Price X on Profits 28.0% manufacturer's gain retailer's gain supply chain gain 24.0% 20.0% 16.0% 12.0% 8.0% 4.0% 0.0% 55 60 65 70 75 option exercise price X -4.0% 80 Profits Impact of Wholesale Price W on Profits Manufacturer 138000 Retailer Total 123000 108000 93000 78000 63000 48000 33000 18000 3000 40 45 50 55 60 Wholesale Price W 65 % gain of Profits Impact of Penalty Cost P on Profits 27.0% manufacturer's gain retailer's gain supply chain gain 24.0% 21.0% 18.0% 15.0% 12.0% 9.0% 6.0% 3.0% 40 45 50 55 60 65 70 75 80 85 90 95 penalty cost P 100 Product Availability Insurance Cost C and Insurance Income Insurance Income 14000 12000 10000 Insurance Income 8000 6000 4000 2000 Insurance Cost C 0 0 5 10 15 20 Impact of Costs C on Profits % gain of profit 54.0% 45.0% 36.0% manufacturer's gain retailer's gain supply chain gain 27.0% 18.0% 9.0% 0.0% -9.0% -18.0% 0 5 10 15 insurance cost c 20 Future Research Directions Supply chain option pricing Expand the framework to consider: Multiple periods Multiple suppliers Multiple buyers Issues associated with creating markets to trade supply chain options