Mean-variance trade-offs in supply contracts

  1. Victor Martínez-de-Albéniz1,
  2. David Simchi-Levi2,*

Article first published online: 28 JUL 2006

DOI: 10.1002/nav.20186

Issue

Naval Research Logistics (NRL)

Naval Research Logistics (NRL)

Special Issue: Special Issue on Applications of Financial Engineering in Operations, Production, Services, Logistics, and Management

Volume 53, Issue 7, pages 603–616, October 2006

Additional Information

How to Cite

Martínez-de-Albéniz, V. and Simchi-Levi, D. (2006), Mean-variance trade-offs in supply contracts. Naval Research Logistics, 53: 603–616. doi: 10.1002/nav.20186

Author Information

  1. 1

    IESE Business School, Barcelona, Spain

  2. 2

    Operations Research Center, MIT, Cambridge, Massachusetts

*Operations Research Center, MIT, Cambridge, Massachusetts

Publication History

  1. Issue published online: 29 AUG 2006
  2. Article first published online: 28 JUL 2006
  3. Manuscript Accepted: 28 FEB 2006
  4. Manuscript Revised: 29 SEP 2005
  5. Manuscript Received: 1 NOV 2004

Funded by

  • Center of eBusiness. Grant Numbers: N00014-95-1-0232, N00014-01-1-0146
  • NSF. Grant Numbers: DMI-9732795, DMI-0085683, DMI-0245352
  • International Center for Logistics Research–CIIL

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Keywords:

  • supply contracts;
  • portfolio;
  • capacity management

Abstract

We study the trade-offs faced by a manufacturer signing a portfolio of long-term contracts with its suppliers and having access to a spot market. The manufacturer incurs inventory risk when purchasing too many contracts and spot price risk when buying too few. We quantify these risks for a single selling period by studying the profit mean and variance for a given portfolio of option contracts. We characterize the set of efficient portfolios that the manufacturer must hold in order to obtain dominating mean-variance pairs. Among these, we emphasize the maximum expectation portfolio, obtained by solving the classical newsvendor problem, and the corresponding minimum variance portfolio. We show that the upper-level sets of a mean-variance utility function are connected. Hence, a greedy method will find the portfolios on the efficient frontier. Finally, we provide a comparison with standard hedging strategies and show that the approximation associated with financial hedging can be relatively inaccurate. © 2006 Wiley Periodicals, Inc. Naval Research Logistics 2006

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