Article thumbnail

Modeling breach of contract risk through bundled options

By Çağrı Haksöz, Cagri Haksoz, Koray Deniz Şimşek and Koray Deniz Simsek

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 numerically show that the bundled option is more valuable for the contract than either of the options, i.e., 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 sub-additive property. We demonstrate that in the presence of high spot price volatility, the bundled option is more valuable when 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 renegotiation option. We conclude that the commodity supplier should negotiate a supply chain contract with flexible options at the design stage with the buyer, 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

Topics: HD0028 Management. Industrial Management, HD0061 Risk Management, HF4999.2-6182 Business, TS0155-194 Production management. Operations management, HG176.6 Financial engineering
Publisher: Incisive Media
Year: 2010
OAI identifier: oai:research.sabanciuniv.edu:14845

Suggested articles


To submit an update or takedown request for this paper, please submit an Update/Correction/Removal Request.