Supply Risk in Fragile Contracts

Increasing length, complexity and interdependence in supply chain contracts is resulting in more critical and costly supply disruptions, yet despite that risk, commodity procurement is mainly handled via long-term, fixed-price contracts containing naive terms and clauses in the case of breach. Fortunately, spot markets are emerging for a host of commodities, and buyers can use these to make up for the lost supply. However, since future spot prices are uncertain, the prospect of trading in these markets exposes buyers to a different type of risk. The challenge is how to manage the interrelated issues of demand, spot prices and breach risks. To analyze this question, we built a model for fragile contracts with interacting demand, spot price and contract breach uncertainties. The model incorporates additional features such as transaction costs incurred by buyers for trading in spot markets and supplier penalties for breaching the contract.