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

• Date: 01 July 2019
• Published date: 01 July 2019
• Author: Xu Chen,Nana Wan
• DOI: http://doi.org/10.1111/itor.12372

Intl. Trans. in Op. Res. 26 (2019) 1451–1474

DOI: 10.1111/itor.12372

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RESEARCH

The role of put option contracts in supply chain management

under inflation

Nana Wan and Xu Chen

School of Management and Economics, University of ElectronicScience and Technology of China, Chengdu, China

E-mail: wannana850417@163.com [Wan]; xchenxchen@263.net [Chen]

Received 15 May2016; received in revised form 19 August 2016; accepted 30 October 2016

Abstract

This paper considers a supply chain consisting of a supplier whomanufactures one type of perishable products

characterized by a long lead time and a retailer who purchases the products from the supplier and sells them

to end consumers. In order to hedge against the risks of price and demand caused by inflation, portfolio

contracts with put options, namely, a combination of wholesale price contracts and put option contracts, are

adopted by the retailer to obtain the products from the supplier. We characterize the optimal ordering and

production policies for the retailer and the supplier in the presence of put option contracts under inflation.

By comparing with the case without put option contracts, we discuss the effectof put option contracts on the

supply chain and prove that the usage of put option contracts benefits these two members under inflation.

Through several numericalexamples, we illustrate the effect of inflation on the supply chain with and without

put option contracts. On this basis, we design a feasible supply chain coordination strategy based on put

option contracts under inflation.

Keywords: supply chain management; risk management; put option contracts; inflation; rising retail price; shrinking

consumer demand

1. Introduction

In the past few years, inflation continues to exert a powerful influence on the global economy.

Most countries around the world, such as Brazil, India, China, and Russia, have been suffering

from high levels of inflation. In these areas, the inflation rate has been remaining far above the

2% target and many problems have resulted. During inflationary periods, the prices of goods and

services maintain a strong upward momentum. Incomes unfortunately cannot catch up with the

rising prices and hence the currency value falls at a rapidrate. As the purchasing power of consumers

has been weakening, there is an apparent volatility in the market sales. In addition, owing to the

rising inflation expectations, the price levels of raw materials increase faster than those of finished

goods. However, the market competition becomes increasingly fierce, which leads to the restriction

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1452 N. Wan and X. Chen / Intl. Trans. in Op. Res. 26 (2019) 1451–1474

of the companies’ pricing power. Thus, the increasing manufacturing costs cannot be transferred

to the sale prices of goods. There is an apparent decrease in the profit margin. A large number of

firms, especially small- and medium-sized firms, fall into a tight spot during inflation. Obviously,

inflation makes a significant impact on the daily operation of firms. Firms are inseparable from

their partners in business practice. Hence, supply chain management plays a most important part

in the success of firms under inflation.

Options, as one of the derivatives of financial instruments, are applied to hedge against various

financial risks including inflation risks in financial applications (Bodie, 1990). With the intersection

and integration of multidisciplinaryknowledge, options, as a type of real options,are introduced into

the supply chain management field (Barnes-Schuster et al., 2002) and become a type of contract

that provides the capacity to respond flexibly to the rapidly changing market. Since then, as an

effective risk hedging instrument, option contracts have attracted a wide spectrum of scholars and

practitioners. Note that wefocus on unilateral option contracts in this paper. 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, 2007; Fu et al., 2010; Inderfurth

et al., 2013; Feng et al., 2014; Xue et al., 2015). 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., 2008; Ren et al., 2010; Haks¨

oz and S¸ims¸ek, 2010; Chen and Shen,

2012). 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. Option contracts are also employed by China Telecom to buy products that are

worth more than 100 billion RMB. Thus, option contracts are thought to protect against the risks

of price and demand caused by inflation.

Unilateral option contracts are classified into twocategories: call option contracts and put option

contracts. In the real world, the above flexible contracts have been widely used in such industries

as agriculture, manufacturing, and transportation (Liu et al., 2013; Nosoohi and Nookabadi, 2016;

Wang and Chen, 2016) in different seasons. For example, in the container shipping industry, call

option contracts are alwaysapplied by the carriers in the peak season while put option contracts are

used in the off-peak season. Recently, we visited some companies that engage in the transaction of

flowers in Hainan provincein China. They launch call option purchasing practice in the busy season

but adopt put option purchasing practice in the slack season. With call (put) option contracts, the

retailer purchases a certain quantity of call (put) options at the upfront unit purchase price before

the selling period begins, and after the customer demand has been realized, a unit prenegotiated

additional exercise price is paid (refunded) to (from) the supplier for obtaining (returning) one

unit of extra product. Obviously, diverse unilateral option contracts exert a different effect on the

retailer’s ordering behavior. It is interesting to observe whether diverse unilateral option contracts

have different impacts on the supplier’s production behavior and even the channel coordination

strategy. Until now, these issues have remained unaddressed and are considered as one of our aims

in this paper.

A number of papers have discussed the inventory management problem for a single company

under inflation (Taheri-Tolgari et al., 2012; Guria et al., 2013; Gilding, 2014). However, they neglect

the analysis of the supply chain management problem under inflation. In addition, a wide range of

studies on option contracts have been published in recent years (Chen and Shen, 2012; Liu et al.,

2013; Hu et al., 2014; Nosoohi and Nookabadi, 2016). However,most of them only consider the risk

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2017 The Authors.

International Transactionsin Operational Research C

2017 International Federation ofOperational Research Societies