Supply Risk Management: Financial Subsidies, Competition, and Asymmetric Information

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2. Outline. Supply Risk ManagementDefinitionExamplesRisk Management ToolsFinancial SubsidiesAsymmetric Information CompetitionChallenges and Opportunities. 3. Supply chain management (Tang 2005 and V.B.)Management of material, information, and financial flows through a network of organizatio

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1. Supply Risk Management: Financial Subsidies, Competition, and Asymmetric Information Volodymyr (Vlad) Babich Industrial and Operations Engineering University of Michigan

2. 2 Outline Supply Risk Management Definition Examples Risk Management Tools Financial Subsidies Asymmetric Information Competition Challenges and Opportunities

3. 3 Supply Risk Management. Definitions

4. 4 Natural disasters and pandemics Nokia vs. Ericsson 2000 ($400m. loss) Aisin Seiki and Toyota 1997 Hurricane Katrina 2005 Taiwan Earthquake 1999 (Dell vs Apple) Bankruptcies UPF-Thompson (chassis) and Land Rover (Discovery model) 2001 Delphi 2005 Labor strikes California dockworker strike 2002 (retail goods shortage) Terrorism 9/11 (trucks delayed on Canadian border) Economy-wide financial shocks Bank runs IT failures and disruptions Changes in laws and regulations Fraud and human error Supply Risks. Causes

5. 5 Hendricks & Singhal (2003, 2005a, 2005b) Declining operating performance 7% decline in sales growths, 11% increase in costs, 13% increase in inventories Declining market value (stock price) – 10% abnormal return over two days following the announcement; – 40% abnormal return over 3 years Supply Risks. Consequences

6. 6 Process improvement (risk culture) Risk assessment, due diligence and monitoring Chief Risk Officer and Risk Departments Contingency planning and training Collaboration with suppliers Insurance Finance Economic capital Financial securities (traded and OTC) Subsidies to suppliers Operations Internal fabrication Higher inventory Flexible production Multi-sourcing and back-up suppliers Marketing Demand management (CRM) Product design Modular product design Infrastructure investments Supply Risks Management Tools

7. 7 Process improvement (risk culture) Risk assessment, due diligence and monitoring Chief Risk Officer and Risk Departments Contingency planning and training Collaboration with suppliers Insurance Finance Economic capital Financial securities (traded and OTC) Subsidies to suppliers Operations Internal fabrication Higher inventory Flexible production Multi-sourcing and back-up suppliers Marketing Demand management (CRM) Product design Modular product design Infrastructure investments Supply Risks Management Tools. Main Drivers After I am done with the information on this slide, make it animated by replicating it over several slides and introducing new colors graduallyAfter I am done with the information on this slide, make it animated by replicating it over several slides and introducing new colors gradually

8. 8 Typical Assumptions of Financial Risk Management. Distribution of asset returns cannot be affected by the composition of your portfolio or by buying or selling (for most investors) There is no private information that the buyers of financial assets can extract from the sellers

9. 9 Features of Non-financial Risks. I Actions of some firms may affect the underlying risk processes E.g. we may be able to change distribution of Y by financial subsidies to the suppliers

10. 10 Features of Non-financial Risks. II Multiple decision makers in supply chains Unlike the traditional financial portfolio problem, parameters (wholesale price, option price) are endogenously determined e.g. h and p may be affected by supplier competition

11. 11 Features of Non-financial Risks. III Some firms might be better informed than others about supply chain risk profile (suppliers have more knowledge about Y ) Screening, signaling, and moral hazard problems Use contract theory together with risk management tools to reduce uncertainty

12. 12 Outline Supply Risk Management Definition Examples Risk Management Tools Financial Subsidies Asymmetric Information Competition Challenges and Opportunities

13. Dealing with Supplier Bankruptcies: the Costs and Benefits of Financial Subsidies Volodymyr Babich Industrial and Operations Engineering University of Michigan

14. 14 Delphi – GM Visteon – Ford Visteon Corp.: Considered bankruptcy in 2005 65% of sales are to Ford Ford Motor Co. Agreed to pay $1.6 billion in May 2005 to buy back and restructure 24 Visteon factories

15. 15 Research Questions How to model supplier financial state and its effect on supplier operational performance? What are costs and benefits of financial subsidies from manufacturers to suppliers? What are the optimal joint order and financial subsidy policies of the manufacturer? Should the manufacturer share supply chain profit with its suppliers?

16. 16 Model and Assumptions Decision maker: manufacturer One supplier Dynamic, periodic review capacity reservation model Actions of the manufacturer may affect supplier financial state and production capacity Risk-neutral manufacturer or risk-neutral valuation Risk-free rate: r, ? = e–r?, ? – period length Customer demand: i.i.d. random variables

17. 17 Supplier’s Financial State Evolution of suppliers’ assets value Bankruptcy conditions (Assets < Liabilities) Effects of financial subsidies

18. 18 Supplier’s Financial State Evolution of suppliers’ assets value Bankruptcy conditions (Assets < Liabilities) Effects of financial subsidies

19. 19 Supplier’s Financial State Evolution of suppliers’ assets value Bankruptcy conditions (Assets < Liabilities) Effects of financial subsidies

20. 20 z – manufacturer’s order ? – financial subsidy K – effective capacity (depends on distance to bankruptcy) Supplier Random Capacity Change: yield – just say that stochastically proportional yield is common assumption but is not useful in this case. Random capacity is better. Then present various assumptions on K(\theta), highlighting the best assumptions.Change: yield – just say that stochastically proportional yield is common assumption but is not useful in this case. Random capacity is better. Then present various assumptions on K(\theta), highlighting the best assumptions.

21. 21 Manufacturer’s Operational Costs For the realized demand, d, and supplier capacity, y Define We need function to be convex

22. 22 Manufacturer’s Operational Costs. Examples Price taker (newsvendor) Supplier cost is proportional to the capacity, y Linear demand curve Iso-elastic demand curve, 0 < g · 1

23. 23 Manufacturer’s Problem Objective: Minimize expected Decisions: Constraints: z – order quantities q – subsidy States: A – supplier assets Revisit assumptions on discounting and risk neutrality Delete any references to options to change suppliers Need additional slide on the manufacturer’s costs, so that I can introduce general cost function LRevisit assumptions on discounting and risk neutrality Delete any references to options to change suppliers Need additional slide on the manufacturer’s costs, so that I can introduce general cost function L

24. 24 The Optimal Order Quantity, z* Proposition For any subsidy, q , the optimal order quantity, z, satisfies Corollary For the newsvendor model the optimal order quantity, z, is the solution of

25. 25 Bellman equation Constraints Transitions DP Recursion.

26. 26 Optimal Asset Level, a* Proposition Assume that the terminal value function is convex and capacity function q is concave, then are convex, and Vn are convex for all n. Let The optimal asset level a* = max ( Sn , An )

27. 27 Problem with “Subsidies Reduce Liabilities” Model q (? ) is not concave (it is convex)

28. 28 Optimal Subsidy, ?*. Uniqueness First Order Condition Sufficient condition for the problem to be unimodal in q is for function to be non-decreasing

29. 29 Properties of the Model and Solution Value functions are decreasing in the initial supplier assets Subsidize-up-to levels are increasing in the initial supplier assets Monotone relationship between subsidize-up-to levels and operational cost parameters

30. 30 Visteon - Ford Visteon Corp. Considered bankruptcy in 2005 65% of sales are to Ford Ford Motor Co. Agreed to pay $1.6 - $1.8 billion in May 2005 to buy back and restructure 24 Visteon factories and 17,400 workers $300 million for inventory + $250 million loan + $500 million per year

31. 31 Visteon – Ford. Newsvendor Model Parameters r = ? = 3.7% (LIBOR); D = k = 6,500,000 (# of cars sold in 2005); p = $5000 per car (gross profit) F = $3.84 billion (current liabilities); A = $4.34 billion (E = $0.5 billion); ? = 0.23 (?E = 0.55, ?D = 0.19) f = $3.84 billion; a = f 2

32. 32 Visteon – Ford. One Period Model

33. 33 Visteon – Ford. N – period model

34. 34 Summary and Conclusions Quantify the benefits and costs of financial subsidies from manufacturer to supplier Combine financial bankruptcy model with operational dynamic capacity reservation model Optimal orders do not depend on subsidy amounts, in particular, they satisfy newsvendor fractile expression for the newsvendor operational costs model. “Subsidize-up-to” policy for subsidies Comparative statics and Ford-Visteon case study Conditions for the manufacturer to share profits with the supplier Symmetric information and zero supplier market power

35. 35 Q&A

36. 36 Outline Supply Risk Management Definition Examples Risk Management Tools Financial Subsidies Asymmetric Information Competition Challenges and Opportunities

37. Supply Risk Management: Asymmetric Information and Backup Production Option Zhibin Yang, Goker Aydin, Volodymyr Babich, Industrial and Operations Engineering Damian Beil Stephen M. Ross School of Business University of Michigan

38. 38 Fire at Toyota’s Supplier, 1997 A fire broke out at Aisin Seiki facility, the only supplier of Toyota for P-valves The fire threatened to interrupt Toyota’s production In Feb, 1997, a fire broke out at Toyota’s supplier, Aisin Seiki facility. The fire burned the production line. Aisin Seiki was the only supplier of p-valves, a small component in the brake system. The fire threatened to stop the production of almost all Toyota’s models. Within just a few days, Aisin Seiki was able to pull up alternative production lines, with the help from other members of Toyota group, and resumed the supply. The supplier can always obtain backup supplier by paying extra money. In this case, it cost Aisin Seiki 7.8B and Toyota 20B to create backup supply. [CONNECTION] It is hard to prepare for a disruption like this. What makes it harder is the fact that very often manufacturers are doing business without full knowledge about the risk associated with their suppliers. [Supporting materials] (1) Aisin was then the only supplier of P-valve in the group, and all other members had no previous experience of producing P-valve and neither did they stay in the P-valve business afterwards. They served totally as a backup to Aisin Seiki. (2) The alternative supply was created without intervention from Toyota. It was Aisin Seiki initiated and managed the creation of . In this single example, Aisin’s access to backup source to saved Toyota and the supply chain. But using backup option imposes extra cost on both the supplier and the manufacturer. (Optional) Supplier’s backup source exists in a variety of forms. For example, a second reliable production line will do the job, but usually more expensive. A lower-tier supplier can also serve the purpose in case of disruption. ** Supporting materials ** In Feb, 1997, a fire broke out at Toyota’s supplier, Aisin Seiki facility. The fire burned the production line. Aisin Seiki was the only supplier of p-valves, a small component in the brake system. The fire threatened to stop the production of almost all Toyota’s models. Within just a few days, Aisin Seiki was able to pull up alternative production lines, with the help from other members of Toyota group, and resumed the supply. The supplier can always obtain backup supplier by paying extra money. In this case, it cost Aisin Seiki 7.8B and Toyota 20B to create backup supply. [CONNECTION] It is hard to prepare for a disruption like this. What makes it harder is the fact that very often manufacturers are doing business without full knowledge about the risk associated with their suppliers. [Supporting materials] (1) Aisin was then the only supplier of P-valve in the group, and all other members had no previous experience of producing P-valve and neither did they stay in the P-valve business afterwards. They served totally as a backup to Aisin Seiki. (2) The alternative supply was created without intervention from Toyota. It was Aisin Seiki initiated and managed the creation of . In this single example, Aisin’s access to backup source to saved Toyota and the supply chain. But using backup option imposes extra cost on both the supplier and the manufacturer. (Optional) Supplier’s backup source exists in a variety of forms. For example, a second reliable production line will do the job, but usually more expensive. A lower-tier supplier can also serve the purpose in case of disruption. ** Supporting materials **

39. 39 Asymmetric Information about Supplier Reliability Bankruptcy of Land Rover’s chassis supplier, 2001 UPF-Thompson announced a bankruptcy and was taken over by KPMG KPMG demanded £35M good-will payment from Land Rover, to continue the chassis supply Land Rover was unaware of the looming risk of bankruptcy, but UPF-Thompson knew about it. Supplier’s private information Common in decentralized systems Supplier may misrepresent itself

40. 40 Problem Description Backup production accessible by suppliers Asymmetric information about supplier reliability [CONNECTION] We solve manufacturers’ procurement problem which combines two prominent features from the two stories I just told. The Aisin - Toyota’s example shows that suppliers may have access to backup production. When a disruption occurs at the supplier, the supplier has two choices: (1) to run backup production to make up for the shortage but at extra production cost. This extra cost will eventually translate into a cost increase with the manufacturer, as we have seen in the [Toyota’s] story. Otherwise, (2) the supplier may do nothing, but pays a penalty. The manufacturer suffers a loss of revenue. If the manufacturer knows perfectly the supplier’s disruption risk, it may be able to prepare for it accordingly: decide which supplier to work with, and how to structure procurement contract – to Force supplier use back-up production or pay penalty. However, UPF- Thompson - Landrover’s example tells us that manufacturers could be uninformed about disruption risk of their suppliers. This asymmetric information makes it harder for a manufacturer to tell What’s the likelihood a supply disruption occurs? How will the supplier manage the risk? What’s the financial consequence of the disruptions on the manufacturer? and Overall, how the manufacturer should do business with the supplier? It is important that the manufacturer designs the procurement contract that accounts for asymmetric information about the supplier’s reliability information. [DISCUSSION] Backup production and AI are two feature we observe. Backup production rather captures the supplier’s tradeoff of whether or not to divert the shortage to the buyer. AI captures a nature of buyer-supplier relation. With AI, the manufacture can not influence the supplier precisely. In equilibrium, the buyer incurs higher cost (informational rent) on exerting its power. [CONNECTION] We solve manufacturers’ procurement problem which combines two prominent features from the two stories I just told. The Aisin - Toyota’s example shows that suppliers may have access to backup production. When a disruption occurs at the supplier, the supplier has two choices: (1) to run backup production to make up for the shortage but at extra production cost. This extra cost will eventually translate into a cost increase with the manufacturer, as we have seen in the [Toyota’s] story. Otherwise, (2) the supplier may do nothing, but pays a penalty. The manufacturer suffers a loss of revenue. If the manufacturer knows perfectly the supplier’s disruption risk, it may be able to prepare for it accordingly: decide which supplier to work with, and how to structure procurement contract – to Force supplier use back-up production or pay penalty. However, UPF- Thompson - Landrover’s example tells us that manufacturers could be uninformed about disruption risk of their suppliers. This asymmetric information makes it harder for a manufacturer to tell What’s the likelihood a supply disruption occurs? How will the supplier manage the risk? What’s the financial consequence of the disruptions on the manufacturer? and Overall, how the manufacturer should do business with the supplier? It is important that the manufacturer designs the procurement contract that accounts for asymmetric information about the supplier’s reliability information. [DISCUSSION] Backup production and AI are two feature we observe. Backup production rather captures the supplier’s tradeoff of whether or not to divert the shortage to the buyer. AI captures a nature of buyer-supplier relation. With AI, the manufacture can not influence the supplier precisely. In equilibrium, the buyer incurs higher cost (informational rent) on exerting its power.

41. 41 Research Questions Interaction: risk management strategies and asymmetric information about supplier reliability Effect of asymmetric information on risk management Value of symmetric information Value of backup production Information and backup production option: complements or substitutes? We want to understand how risk management and asymmetric information interact. Specifically, How to model and measure effect of AI on risk management? what’s the value of information? What’s the value of having backup production at the supplier Are they complements or substitutes ?We want to understand how risk management and asymmetric information interact. Specifically, How to model and measure effect of AI on risk management? what’s the value of information? What’s the value of having backup production at the supplier Are they complements or substitutes ?

42. 42 Model One supplier, one manufacturer, one product, one period Suppliers are subject to random production disruptions Supplier reliability: “high” or “low” Has a backup production option Game-theoretic contract-design problem Strategic behavior of the supplier Revelation principle and mechanism design Manufacturer offers a menu of two contracts (one per supplier type): Transfer payment – X order quantity – q non-delivery unit penalty – p

43. 43 Model – Timing of Events [TIMING] At time zero, the nature reveals the type of the supplier but the manufacturer. Unaware of the type of the supplier, the manufacture design a menu of contract for each type of supplier. If the supplier rejects the contract, no action is taken. If otherwise, the supplier reveal its type and picks a contract, and the contract is executed. ** Question: Why do we assume payment is a lump sum and pay upfront, not a linear cost? Lump sum payment allows any possible form of payment is more general in this case. This is appropriate in a supply procurement setting. BTW, in this specific setting, the payment in the optimal solution is Why do we assume the manufacturer pays upfront? What if the manufacturer pays upon deliver? The assumption that the supplier pays a penalty in case of disruption implies that fact that the manufacturer is paying upon delivery. Why one period? We did not include the effect of the player learning from previous interaction since this research is designed to study the effect of asymmetric information. What if there are two periods? (manufacturer learning, will be a nice extension) ** Research idea: timing the payment to induce information. [TIMING] At time zero, the nature reveals the type of the supplier but the manufacturer. Unaware of the type of the supplier, the manufacture design a menu of contract for each type of supplier. If the supplier rejects the contract, no action is taken. If otherwise, the supplier reveal its type and picks a contract, and the contract is executed. ** Question: Why do we assume payment is a lump sum and pay upfront, not a linear cost? Lump sum payment allows any possible form of payment is more general in this case. This is appropriate in a supply procurement setting. BTW, in this specific setting, the payment in the optimal solution is Why do we assume the manufacturer pays upfront? What if the manufacturer pays upon deliver? The assumption that the supplier pays a penalty in case of disruption implies that fact that the manufacturer is paying upon delivery. Why one period? We did not include the effect of the player learning from previous interaction since this research is designed to study the effect of asymmetric information. What if there are two periods? (manufacturer learning, will be a nice extension) ** Research idea: timing the payment to induce information.

44. 44 Model – Manufacturer’s Contract Design We model the manufacturer’s contract design problem as standard mechanism design. (to clarify our contribution is not on the methodology, avoid potential confusion in advance.) In this game, the manufacturer is the leader, and designs a menu of two contracts, each for a type of supplier. Each contract is comprised of transfer payment, penalty and quantity Upon accepting a contract, the supplier produces optimally, by deciding (a) the input size of regular production and (b) the level of backup production in case of disruption. The supplier’s profit is made up of transfer payment, less the The manufacturer’s objective to maximize its expected profit before the supplier’s type is revealed. The manufacturer’s profit is made up of the revenue income minus payment transfer to the supplier, X, plus any penalty receivable if the supplier under-delivers. By revelation principle, we are able to restrict the problem to only direct revelation mechanisms. The manufacturer is subject to incentive compatibility and individual rationality constraints. [Note 1] that if the manufacturer knows exactly the type of the supplier, it is able to induce the supplier to manage its risk by either paying a penalty or using backup production, by imposing a appropriate level of penalty cost. (For instance, if p>b, then the supplier will run backup production when a disruption occurs.) [Note 2] today, we are going to enter the details of the model, but rather show you the results. [Questions] Is the contract with penalty a general form? I have to admit that many procurement contracts do not include a penalty term, especially if they don’t take into account the possibility of disruption. The penalty in our contract captures the fact that the manufacturer can exert its financial incentive to affect the supplier’s production decision in face of disruption, which is rather common in practice. To that purpose, a contract with penalty term is general. I would like to emphasize, again, that the primary purpose of this research is not to provide guideline for designing a contract. It is rather designed to help people understand the interaction and relationship between the supplier and the manufacturer in face of supply uncertainty. We model the manufacturer’s contract design problem as standard mechanism design. (to clarify our contribution is not on the methodology, avoid potential confusion in advance.) In this game, the manufacturer is the leader, and designs a menu of two contracts, each for a type of supplier. Each contract is comprised of transfer payment, penalty and quantity Upon accepting a contract, the supplier produces optimally, by deciding (a) the input size of regular production and (b) the level of backup production in case of disruption. The supplier’s profit is made up of transfer payment, less the The manufacturer’s objective to maximize its expected profit before the supplier’s type is revealed. The manufacturer’s profit is made up of the revenue income minus payment transfer to the supplier, X, plus any penalty receivable if the supplier under-delivers. By revelation principle, we are able to restrict the problem to only direct revelation mechanisms. The manufacturer is subject to incentive compatibility and individual rationality constraints. [Note 1] that if the manufacturer knows exactly the type of the supplier, it is able to induce the supplier to manage its risk by either paying a penalty or using backup production, by imposing a appropriate level of penalty cost. (For instance, if p>b, then the supplier will run backup production when a disruption occurs.) [Note 2] today, we are going to enter the details of the model, but rather show you the results. [Questions] Is the contract with penalty a general form? I have to admit that many procurement contracts do not include a penalty term, especially if they don’t take into account the possibility of disruption. The penalty in our contract captures the fact that the manufacturer can exert its financial incentive to affect the supplier’s production decision in face of disruption, which is rather common in practice. To that purpose, a contract with penalty term is general. I would like to emphasize, again, that the primary purpose of this research is not to provide guideline for designing a contract. It is rather designed to help people understand the interaction and relationship between the supplier and the manufacturer in face of supply uncertainty.

45. 45 Manufacturer’s Key Trade-off High-type supplier has incentive to pretend to be low-type To exploit its higher reliability (lower expected cost) To extract informational rent in equilibrium To reduce informational rent manufacturer incurs operational loss by changing the contract with the low-type supplier

46. 46 Optimal Contract and Effect of Asymmetric Information

47. 47 Optimal Contract and Effect of Asymmetric Information

48. 48 Value of Information Information is most valuable for the manufacturer when backup production cost is moderate

49. 49 Value of Backup Production Option Cheap backup production hurts high-type supplier when r is large

50. 50 Conclusions Model Two-echelon supplier chain, single supplier Asymmetric information about supplier reliability Suppliers have backup production option Manufacturer faces a key trade-off between Informational rent to a high-type supplier Operational loss with a low-type supplier

51. 51 Conclusions Two approaches to reduce supply uncertainty: Work with suppliers with backup production option Gather information about the supplier Information is most valuable when backup production cost is moderate Manufacturer suffers from both from informational rent and from operational losses Existence of cheap backup production option decreases the value of information for the manufacturer Backup production option Benefits the manufacturer May hurt reliable suppliers

52. 52 Q&A

53. 53 Outline Supply Risk Management Definition Examples Risk Management Tools Financial Subsidies Asymmetric Information Competition Challenges and Opportunities

54. Supply Risk Management: Diversification and Competition Volodymyr Babich, University of Michigan Apostolos Burnetas University of Athens Peter Ritchken Case Western Reserve University

55. 55 Multi-Sourcing Empirical Evidence: Multi-sourcing is widely used --- Lester 2002: 15% of Japanese companies operating in the domestic market single source components Main reasons to have multiple suppliers (Wu and Choi 2005): Competition and Diversification

56. 56 What are the effects of risk on Suppliers’ pricing decisions? Timing of payments Retailer’s order policy? Lowest price vs. Diversification What are the benefits of diversification? How does competition and default correlation affect benefits of diversification? Retailer may benefits from positive default correlation Research Questions (and Some Answers) So, how much exactly does the retailer suffer from credit risk? What is the effect of risk on the retailer’s order policy, supplier selection process? Without credit risk, everything else being equal the retailer will order from the supplier with the lowest wholesale price. However, with supplier credit risk the retailer may profit from diversification by splitting the order among several suppliers. What is the extent of the diversification benefits and how does it depend on the correlation between supplier defaults? The benefits of diversification increase as the correlation between defaults decreases, with perfect negative correlation yielding the highest benefits. Therefore, intuitively, the when wholesale prices are exogenously fixed the retailer will prefer suppliers whose defaults are perfectly negatively correlated. However, credit risk affect not only retailer’s ordering policy but also suppliers’ pricing policies and, therefore, if the wholesale prices are endogenous to the model, the effect of correlation is not clear a priori Intuitively, because benefits of risk diversification increase as the default correlation decreases The timing of payments becomes very important. In the presence of default order are no longer a binding forward contract, but rather a risky contractual arrangement. The retailer will be more reluctant to pay up-front, because goods may not be delivered. On the other hand the supplier would like to have some collateral of good faith money that signals the retailer’s true commitment. As a result contacts will contain some form of mixture between up-front and on-delivery payment arrangements. So, how much exactly does the retailer suffer from credit risk? What is the effect of risk on the retailer’s order policy, supplier selection process? Without credit risk, everything else being equal the retailer will order from the supplier with the lowest wholesale price. However, with supplier credit risk the retailer may profit from diversification by splitting the order among several suppliers. What is the extent of the diversification benefits and how does it depend on the correlation between supplier defaults? The benefits of diversification increase as the correlation between defaults decreases, with perfect negative correlation yielding the highest benefits. Therefore, intuitively, the when wholesale prices are exogenously fixed the retailer will prefer suppliers whose defaults are perfectly negatively correlated. However, credit risk affect not only retailer’s ordering policy but also suppliers’ pricing policies and, therefore, if the wholesale prices are endogenous to the model, the effect of correlation is not clear a priori Intuitively, because benefits of risk diversification increase as the default correlation decreases The timing of payments becomes very important. In the presence of default order are no longer a binding forward contract, but rather a risky contractual arrangement. The retailer will be more reluctant to pay up-front, because goods may not be delivered. On the other hand the supplier would like to have some collateral of good faith money that signals the retailer’s true commitment. As a result contacts will contain some form of mixture between up-front and on-delivery payment arrangements.

57. 57 Model Joint distribution of supplier defaults (?) is given Retailer’s optimization problem: Suppliers’ game

58. 58 Modeling Codependence Linear correlation (Pearson’s) might not be adequate for non-elliptic distributions (Embrechts, McNeil, and Straumann 2002) Copula functions (Nelsen 1999, Embrechts, Lindskog, and McNeil 2003) --- difficult to choose appropriate class of copulas Direct approach, N = 2 Given

59. 59 2-Suppliers. Deterministic Demand. Equilibrium For simplicity, let’s start with the model where demand is deterministic. Once we understand the effects of correlation on this simple model it will be easier for us to extend result to more general stochastic demand model. This is a graph of the retailer’s response. If wholesale prices are in the top left region the retailer will order D from the first supplier and 0 from the second one. If wholesale prices are in the top right region then the ordering is reversed. In the bottom left region the retailer will order D from each supplier and on the line the retailer will order positive quantities from each supplier so that the total order quantity is D. Note that retailer’s response would have been very different without credit risk. Without credit risk the retailer would order D units from the supplier with the lowest wholesale price. If you think about retailer’s response for a minute it becomes clear what the equilibrium solution of game between suppliers is. We would like to know how does equilibrium solution depend on the correlation between supplier’s defaults. Also we would like to know how do profits depend on the correlation between supplier’s defaults. To measure the correlation we will look at values of p_01, p_10, p_00 – probability that the first supplier survives and the second one defaults ,…. For example, if defaults are perfectly positively correlated then p_01 = p_10 = 0. Conversely, if defaults are perfectly negatively correlated, then p_00 = 0 Lets start with the perfectly negatively correlated defaults. As I mentioned, in this case, p_00 = 0. For any feasible K the retailer will order D from both suppliers, hence the response region looks like this. He equilibrium solution is to charge highest possible K. The rectangle on the right represents total system profits. We can see that suppliers collect all of the system profits leaving nothing to the retailer.For simplicity, let’s start with the model where demand is deterministic. Once we understand the effects of correlation on this simple model it will be easier for us to extend result to more general stochastic demand model. This is a graph of the retailer’s response. If wholesale prices are in the top left region the retailer will order D from the first supplier and 0 from the second one. If wholesale prices are in the top right region then the ordering is reversed. In the bottom left region the retailer will order D from each supplier and on the line the retailer will order positive quantities from each supplier so that the total order quantity is D. Note that retailer’s response would have been very different without credit risk. Without credit risk the retailer would order D units from the supplier with the lowest wholesale price. If you think about retailer’s response for a minute it becomes clear what the equilibrium solution of game between suppliers is. We would like to know how does equilibrium solution depend on the correlation between supplier’s defaults. Also we would like to know how do profits depend on the correlation between supplier’s defaults. To measure the correlation we will look at values of p_01, p_10, p_00 – probability that the first supplier survives and the second one defaults ,…. For example, if defaults are perfectly positively correlated then p_01 = p_10 = 0. Conversely, if defaults are perfectly negatively correlated, then p_00 = 0 Lets start with the perfectly negatively correlated defaults. As I mentioned, in this case, p_00 = 0. For any feasible K the retailer will order D from both suppliers, hence the response region looks like this. He equilibrium solution is to charge highest possible K. The rectangle on the right represents total system profits. We can see that suppliers collect all of the system profits leaving nothing to the retailer.

60. 60 Effects of Correlation

61. 61 Effects of Correlation

62. 62 Effects of Correlation

63. 63 Effects of Correlation

64. 64 Effects of Correlation

65. 65 Effects of Correlation

66. 66 Effects of Correlation

67. 67 Effects of Correlation

68. 68 2-Suppliers. Effects of Correlation – Insights Observations: The retailer would prefer positively correlated defaults of the suppliers The suppliers (and the system) prefer negatively correlated defaults Equilibrium prices decrease in correlation The benefits of competition outweigh the benefits of diversification Why? If supplier defaults are perfectly correlated, the product they offer are perfectly substitutable and Bertrand competition drives prices down If supplier defaults are negatively correlated, the products are not substitutable, there is no competition, and each supplier behaves as a monopolist.

69. 69 3-Supplier Equilibriums Provide conditions for equilibrium with 3-, 2-, 1- suppliers Explicit expressions for equilibrium profits

70. 70 N-Suppliers The more suppliers are available, the lower are the equilibrium prices If it is possible to divide suppliers into groups, where within each group suppliers are perfectly correlated, then the retailer can benefit both from competition and diversification Let’s discuss the model we used to analyze the effects of the deferment option in greater detail. We consider a one period, multi-stage model of a two-echelon supply chain with two competing, risky suppliers and a retailer. The suppliers and the retailer are maximizing their expected (with respect to a risk-neutral measure) discounted profits. Recall that L_1, L_2 are suppliers’ lead times and L_R is the retailer’s lead time. We introduce the following notation: T – time when product is in demand. We assume that the retailer’s storage costs are exorbitantly high. Therefore, the finished product has to be sold immediately and, in addition, the production must commence right after the raw materials have been provided by a supplier. Consequently, the retailer will not order from supplier 1 prior to T - LR - L1 (designated as time 0) and from supplier 2 prior to time \tau_1 = T - LR - L2. We assume that the evolution of retail price S(t) over time can be described by a geometric Wiener process (under a risk-neutral measure): The retailer has capacity D and variable production cost c_R. Exogenous events may cause a supplier’s default at any time. Suppliers variable production costs are c_k and they are incurred before production begins. The exact sequence of events during planning horizon, [0, T], depends on the type of contractual arrangements between the suppliers and the retailer. One possibility is for the firms to negotiate at time 0 contracts that stipulate wholesale prices and order quantities for both suppliers. Alternatively, the retailer and supplier 2 may defer the negotiation until time 1. The outcome of the negotiation depends on the bargaining power of suppliers and the retailer. All firms have complete and symmetric information about the problem. Let’s discuss the model we used to analyze the effects of the deferment option in greater detail. We consider a one period, multi-stage model of a two-echelon supply chain with two competing, risky suppliers and a retailer. The suppliers and the retailer are maximizing their expected (with respect to a risk-neutral measure) discounted profits. Recall that L_1, L_2 are suppliers’ lead times and L_R is the retailer’s lead time. We introduce the following notation: T – time when product is in demand. We assume that the retailer’s storage costs are exorbitantly high. Therefore, the finished product has to be sold immediately and, in addition, the production must commence right after the raw materials have been provided by a supplier. Consequently, the retailer will not order from supplier 1 prior to T - LR - L1 (designated as time 0) and from supplier 2 prior to time \tau_1 = T - LR - L2. We assume that the evolution of retail price S(t) over time can be described by a geometric Wiener process (under a risk-neutral measure): The retailer has capacity D and variable production cost c_R. Exogenous events may cause a supplier’s default at any time. Suppliers variable production costs are c_k and they are incurred before production begins. The exact sequence of events during planning horizon, [0, T], depends on the type of contractual arrangements between the suppliers and the retailer. One possibility is for the firms to negotiate at time 0 contracts that stipulate wholesale prices and order quantities for both suppliers. Alternatively, the retailer and supplier 2 may defer the negotiation until time 1. The outcome of the negotiation depends on the bargaining power of suppliers and the retailer. All firms have complete and symmetric information about the problem.

71. 71 2-Suppliers. Stochastic Demand. Equilibrium Identical suppliers Demand has mean 150 and standard deviation 50 Codependence between supplier defaults increases in p00

72. 72 Centralized vs. Decentralized Systems As the codependence between defaults increases, the system becomes more coordinated However, total system profits are decreasing

73. 73 Effect of Survival Probability Independent defaults Supplier’s profits are non-monotone

74. 74 Timing of Payments In equilibrium the retailer and the suppliers are indifferent between the timing of payments, if the payments are linear in quantities The up-front prices take into account survival probability

75. 75 Summary and Conclusions N-supplier equilibrium with either deterministic or stochastic demand Exogenous wholesale prices ? the negative codependence between defaults benefits the retailer and the system Endogenous wholesale prices ? the retailer may benefit from positive default codependence competition among suppliers drives down wholesale prices With more than two suppliers it is possible for the retailer to enjoy benefits of competition and diversification simultaneously The wholesale prices and profits of suppliers could be non-monotone in their survival probability If payment policies are linear in the order quantity ? in equilibrium, the suppliers and the retailer are indifferent between up-front and on-delivery payments. The on-delivery prices are greater than up-front prices by the survival probability.

76. 76 Q&A

77. 77 Outline Supply Risk Management Definition Examples Risk Management Tools Financial Subsidies Asymmetric Information Competition Challenges and Opportunities

78. 78

79. 79 Trends: Great Interest in the Field 80 participants We were expecting 40 Business, engineering, science, and mathematics fields were represented Researches and practitioners, domestic and international from universities, industry research labs, insurance companies, consulting companies, manufacturing companies participated. Received 54 applications for student poster session 14 were selected Conference sponsors The National Science Foundation; The College of Engineering at the University of Michigan; The Department of Industrial and Operations Engineering at the University of Michigan; The Stephen M. Ross School of Business at the University of Michigan; The Financial Engineering program at the University of Michigan; The Tauber Manufacturing Institute at the University of Michigan; DaimlerChrysler Corporation; Ford Motor Company; General Motors Corporation; Lockheed Martin Corporation

80. 80 Trends: Strategic Role of Risk Management “Old” risk management: hedging exposure in financial markets quantifying the reliability of the equipment “New” risk management: Customer relationship management Market share and competition Mergers and industry consolidation Collaborative relationships with the suppliers

81. 81 Needed: Unified Methodological Approach Risk management in operations and supply chain management Combines operations, finance, actuarial science, reliability and quality control, financial engineering, economics Challenge of integrating the language used by experts of various subfields The broad set of tools is needed to bring together, in practice, interdisciplinary teams within corporations to tackle risk management problems Financial Engineering – discipline for managing and pricing financial risks Risk management in operations and supply chain management - risk and decision analysis in operations

82. 82 Needed: Empirical Research Financial engineering made great impact in practice because of the empirically verifiable results and empirically verifiable successes Integrated risk management in operations and supply chains progress maybe impeded by the lack of data Rare events Intellectual property Proprietary concerns Negative publicity Further work is needed to identify problems for which data is available, to develop new methods of analyzing data, and to create appropriate databases

83. 83 Important Research Opportunities Risk metrics for management in operations. Time-risk tradeoffs Econometric methods for enterprise risk measurement and management Identification of empirically verifiable results and issues Computational methods for managing complex risk portfolios. Coordination between operational and financial decisions (including financing and hedging decisions) Games, the role of incentives, and asymmetric information in risk management

84. 84 Q&A

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