D. Barnes--Schuster, Y. Bassok and R. Anupindi
*** Abstract ****
We investigate the role of options (contingent claims) in a buyer-supplier system. Specifically using a two-period model with correlated demand, we illustrate how options provide flexibility to a buyer to respond to market changes in the second period. We also study the implications of such arrangements between a buyer and a supplier for coordination of the channel. We show that, in general, channel coordination can be achieved only if we allow the exercise price to be piecewise linear. We develop sufficient conditions on the cost parameters such that linear prices coordinate the channel. We derive the appropriate prices for channel coordination which, however, violate the individual rationality constraint for the supplier. We show that use of return policies by the supplier may allow her to satisfy the individual rationality constraint and make positive profits. Return policies, however, are applicable only on a subset of the feasibility region under which channel coordination is achievable with linear prices. We then propose two types of all--unit quantity discount schemes (simple and bundled) that are individually rational and coordinate the channel. Finally, we demonstrate (numerically) the benefits of options in improving channel performance and evaluate the magnitude of loss due to lack of coordination.