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Modeling Breach of Contract Risk through Bundled Options

Haksöz, Çağrı; Şimşek, K.D.

Authors

Çağrı Haksöz

K.D. Şimşek



Abstract

In this paper, in order to model breach of contract risk, we design and value a bundled option that is composed of contract abandonment and price renegotiation. We numerically show that the bundled option is more valuable for the contract than either of the options, i.e., contract abandonment and price renegotiation, in isolation. This value increases monotonically as the spot price becomes more volatile. The value of the bundled option is less than the sum of the individual option values, hence showing the sub-additive property. We demonstrate that in the presence of high spot price volatility, the bundled option is more valuable when renegotiation date is selected to be closer to the half-life of the contract. We also show that early contract abandonment probability goes down in the presence of renegotiation option. We conclude that the commodity supplier should negotiate a supply chain contract with flexible options at the design stage with the buyer, obtaining contract abandonment and price renegotiation options –as a bundled option—in order to enhance the supply contract value and reduce the breach of contract risk.

Citation

Haksöz, Ç., & Şimşek, K. (2010). Modeling Breach of Contract Risk through Bundled Options. Journal of Operational Risk, 5(3), 3-20

Journal Article Type Article
Publication Date 2010
Deposit Date Sep 23, 2019
Journal The Journal of Operational Risk
Print ISSN 1744-6740
Publisher Infopro Digital Services
Volume 5
Issue 3
Pages 3-20.
Keywords Supply chain contracts, Procurement, Breach of contract risk, Abandonment and renegotiation options, Basel II -Clients, Products, Business Practices Category Risks
Public URL https://durham-repository.worktribe.com/output/1290932