Buy-Back Contracts as Options Contracts: A Two-Party Supply Chain Perspective

A buy-back contract is an agreement between a manufacturer and a retailer where the manufacturer agrees to buy back any unsold inventory from the retailer at a predetermined price. This type of contract can be viewed as a special type of options contract, as follows:

Let's assume the manufacturer and retailer agree on a buy-back price of $10 per unit. The buy-back contract can be viewed as an option contract where the retailer has the right, but not the obligation, to sell the unsold inventory back to the manufacturer at the predetermined price of $10 per unit.

To construct an option contract with the same sales and costs as the buy-back contract, we can set the strike price of the option contract equal to the buy-back price of $10 per unit. We can also set the premium of the option contract equal to the difference between the wholesale price and the buy-back price, which represents the cost to the manufacturer of buying back the inventory.

Under this option contract, if the retail demand for the product is high and the retailer sells all of the inventory at the wholesale price, the option will expire worthless, and the retailer will have made a profit equal to the wholesale price minus the premium paid for the option. However, if the retail demand is low and the retailer is unable to sell the inventory, they can exercise the option and sell the inventory back to the manufacturer at the strike price of $10 per unit. In this case, the manufacturer will have to buy back the inventory at the predetermined price, which represents the cost to the manufacturer under the buy-back contract.

Thus, we have constructed an option contract with special parameters where the sales and costs are the same under both the option contract and the buy-back contract. Therefore, we can view the buy-back contract as a special type of options contract.