Modeling breach of contract risk through bundled options

Abstract

In this paper, in order to model breach of contract risk, we design and value a bundled option that is composed of contract abandonment and price renegotiation. We show numerically that the bundled option is more valuable for the contract than either of the options, ie, contract abandonment and price renegotiation, in isolation. This value increases monotonically as the spot price becomes more volatile. The value of the bundled option is less than the sum of the individual option values, hence showing the subadditive property. We demonstrate that in the presence of high spotprice volatility, the bundled option is more valuable when the renegotiation date is selected to be closer to the half-life of the contract. We also show that early contract abandonment probability goes down in the presence of a renegotiation option. We conclude that the commodity supplier should negotiate with the buyer a supply chain contract with flexible options at the design stage, obtaining contract abandonment and price renegotiation options-as a bundled option-in order to enhance the supply contract value and reduce the breach of contract risk.

The role of put option contracts in supply chain management under inflation

“…An increasing number of studies have discussed the flexibility and the benefit derived from the application of option contracts under different research backgrounds (Wang and Liu, ; Fu et al., ; Inderfurth et al., ; Feng et al., ; Xue et al., ). More and more companies, such as Sun, HP, IBM, and China Telecom, successfully adopt option contracts to purchase various inputs and obtain many real benefits (Nagali et al., ; Ren et al., ; Haksöz and Şimşek, ; Chen and Shen, ). For example, HP has established and employed a set of risk management plans based on option contracts to purchase components from suppliers, and has made savings of more than 15 million dollars.…”

Supply Chain Bilateral Coordination with Option Contracts under Inflation Scenarios

“…Option contracts can also help the supply-side make a production plan that maximizes its own profit and provide the supplyside with more flexibility to reduce the production cost. In the real world, many famous companies such as HP [5], Sun [6], and IBM [7] adapt derivatives of option contracts to purchase various inputs such as memory chips and scanner assemblies. Since then, extensive attentions from scholars are paid to option contracts.…”

A copula-based simulation model for supply portfolio risk

“…A recent McKinsey CEO survey report by Gyorey et al (2010) notes that 37% of the CEO respondents stated that, over the next five-year period, they were unprepared for an increase in the volatility of commodity prices. Moreover, commodity price risk is exacerbated in the presence of breach-of-contract risk (Haksöz andŞimşek (2010)). Breach-of-contract risk is a fundamental operational risk classified under "Clients, Products, and Business Processes" as well as the "Execution, Delivery, and Process Management" categories of the Basel II framework (see, for example, Cruz (2002), Chernobai et al (2002), Haksöz and Kadam (2009) and Haksöz andŞimşek (2010) for further details on this type of operational risk).…”