Reducing International Risk through Quantity Contracts

We investigate a tool which small manufacturers engaging in international supply contracts can use to dampen the variations in their income caused by exchange rate uctuations. The method we study involves contractual speci cations for a minimum purchase quantity with the buyer. The particular case we consider is that of a smaller manufacturer providing a product to a large overseas corporation, where transactions are conducted in the manufacturer's domestic currency. The large corporation employs a periodic review inventory policy with back orders, incorporating unit, holding and penalty costs which may be statedependent. The state is the current exchange rate, which varies in a Markovian manner according to one of three considered models (random walk, mean reverting, and momentum). Demands for products arrive randomly and may also be state dependent, to a degree determined by the rate of pass through of exchange rate e ects. We rst establish that the optimal policy for the corporation is an order up to policy with state dependent thresholds. After establishing this, we use computer experimentation to investigate the e ect increasing the minimum purchase quantity has. This minimum order quantity transfers some of the cash ow variance to the customer, which in turn drives the corporation's holding/penalty costs up. To counteract this, the corporation will expect a discount from the smaller supplier. This gives rise to a mean/standard deviation frontier for the supplier's cash ow. We also study the e ects of increasing exibility in order quantity, increased supplier capacity, and the interactions between these two factors. GSIA Working Paper # 1997-42