Option contract application in emergency supply chains

Emergencies, such as natural and man‐made disasters, might impose great amount of uncertainties on companies in supply chains, especially supply chain of relief materials. Risk hedging procedures such as risk‐sharing contracts help the firms to survive from these uncertainties. In this study, an option contract application in relief material supply chains is considered within which a buyer purchase some options from a supplier and has a right, not obligation, to exercise it according to special conditions. In emergencies, condition for option exercising is disaster occurrence which is probabilistic. Our study takes disaster intensity into account via a disaster intensity probability density function, upon which the buyer can exercise a portion of the option contract. In order to motivate both parties to participate in the option contract, an option pricing model based on binomial trees is presented, which optimises option and exercise prices in four different conditions. Also, it is assumed that both parties of the supply chain can negotiate on the obtained prices. In order to validate the model, a numerical example is presented, whose obtained results demonstrate a feasible region for option and exercise price.