Homework__4_Solutions

Homework__4_Solutions - Management Science Engineering 369...

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Spring, 2008 Homework #4 Due: Beginning of class, May 6 1. Contract valuation Questions: a) A supplier of a commodity product offers flexible quantity contracts to its customers. Compare the supplier’s revenue exposure if the contract pricing is: - Index (market) based - Fixed price Which is more risky? Is there an unambiguous answer to this question? Revenue = quantity x price. Under index-based pricing the supplier’s revenue will move up and down with the market price. Since most buyer’s demand is positively correlated with overall market demand, and therefore with market price, revenue exposure will be further increased; when price is down, units will likely be down also, and when price is up, units will likely also be up. Under fixed pricing, price is constant so all revenue exposure comes from number of units sold. If the customer always buys all the supply it requires from the supplier, revenue will vary as the customer’s demand varies, but be lower than under index- based pricing, since price is fixed rather than positively correlated with quantity. However, if the customer can also buy from other sources at prices that move with the market, for example the market itself or a second index-based contract, the supplier’s revenue exposure may increase substantially. Specifically, the supplier’s sales to the customer will increase when the customer’s demand is high, both because the customer has greater overall requirements and because pricing from the customer’s other market price based sources is likely to be high (due to positive price-demand correlation). Similarly, when the customer’s demand is low the supplier’s sales will decrease, both because the customer has lower overall requirements and because pricing from the customer’s other sources is likely to be low, and below the fixed contract price. In summary, it is unclear which pricing alternative will lead to greater revenue exposure. The answer will depend on the level of price-demand correlation, and whether the customer has an alternative source of supply with index-based pricing. b)
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Homework__4_Solutions - Management Science Engineering 369...

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