Purchasing buyer—supplier contracts

The call option in a supply chain works as follows. At the beginning of the period, the retailer places an order of quantity Q, paying a price W for each unit. She also purchases q (call) option contracts from the supplier (at a price c per contract). She now has the right to purchase up to q additional units at the end of the period after demand is realized, at a cost w per unit (exercise price of the option). Under this arrangement, the supplier is committed to produce Q + q units, but can salvage any unexercised options at the end of the period. Thus, the call option transfers some risk from the buyer to the supplier. In scenarios where production lead time is high the buyer must place her order early, so that some uncertainty still remains when the call option is exercised. In this situation, a combination of call and put options can be employed (Erkoc and Wu 2005) that incorporates a put option when the call option is exercised the buyer has the right to return excess orders to the supplier after all demand uncertainty is resolved. 

In choosing suppliers to be included in the supply base, the buyer needs to be concerned about not only the transaction costs but also the long term strategic fit. Typically the buyer identifies, evaluates, and contracts with suppliers. Unreliable suppliers, in terms of quality and fulfillment, increase the buyers cost. In many cases, because of the suppliers capacity constraints, the buyer may need to allocate its purchase order to more than one supplier. 

The buyer would have several options to counter market volatility purchase-postponement, buy-back contract, and use hedging options such the option-to-purchase . The buyer gains by postponing purchase of the items to a time when demand becomes known. This would require the supplier to hold inventory that... 

---