European Journal of Operational Research 152 (2004) 781–799

www.elsevier.com/locate/dsw

Optimal procurement strategies for online spot markets

a,*
Ralf W. Seifert , Ulrich W. Thonemann b, Warren H. Hausman c

a
IMD, International Institute for Management Development, Chemin de Bellerive 23, P.O. Box 915, Lausanne CH-1001,
Switzerland
b
ikb, Universit€at M€unster, Universit€atsstraße 14-16, M€unster D-48143, Germany
c
Department of Management Science and Engineering, Stanford University, Stanford, CA 94305-4026, USA
Received 31 May 2001; accepted 16 September 2002

Abstract

Spot markets have emerged for a broad range of commodities, and companies have started to use them in addition
to their traditional, long-term procurement contracts (forward contracts). In comparison to forward contracts, spot
markets offer products at essentially negligible lead time, but typically command a higher expected price for this added
flexibility while also exhibiting substantial price uncertainty. In our research, we analyze the resulting procurement
challenge and quantify the benefits of using spot markets from a supply chain perspective. We develop and solve
mathematical models that determine the optimal order quantity to purchase via forward contracts and the optimal
quantity to purchase via spot markets. We analyze the most general situation where commodities can be both bought
and sold via a spot market and derive closed-form results for this case. We compare the obtained results to the reference
scenario of pure contract sourcing and we include results for situations where the use of spot markets is restricted to
either buying or selling only. Our approaches can be used by decision makers to determine optimal procurement
strategies based on key parameters such as, demand and spot price volatilities, correlation between demand and spot
prices, and risk aversion. The results of our analysis demonstrate that significant profit improvements can be achieved if
a moderate fraction of the commodity demand is procured via spot markets. The results also show that companies who
use spot markets can offer a higher expected service level, but that they might experience a higher variability in profits
than companies who do not use spot markets. We illustrate our analytical results with numerical examples throughout
the paper.
Ó 2002 Elsevier B.V. All rights reserved.

Keywords: Supply chain management; Purchasing; Internet; Spot markets

1. Introduction supplies and has the potential to radically alter the

The creation of online spot markets provides
for significant opportunities in the procurement of
*
Corresponding author. Tel.: +41-21-618-0111; fax: +41-21-
618-0707.
E-mail address: seifert@imd.ch (R.W. Seifert).
business landscape [1,6,8,21]. While spot markets
have long been used for grains, livestock, and oil
[41], only recently have they been formed for
memory chips, chemicals, energy, telecommunica-
tion bandwidth, etc. Online spot markets are
proliferating relatively rapidly for a broad range of
(near-) commodities with prominent players such

0377-2217/$ - see front matter Ó 2002 Elsevier B.V. All rights reserved.
doi:10.1016/S0377-2217(02)00754-3
782 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
as ChemConnect, AltraNet, E-Steel, PaperEx-
change, and Converge serving as examples [8,21].
Many companies have already started to use spot
markets (whether independent or consortium-
based) in addition to their traditional procurement
via forward contracts. For example, spot market
volumes as a percentage of total volume are esti-
mated to account for 5% of chemicals and steel
sales [2,9] and up to 30% of memory chips sales
[13,18]. Yet, many companies appear to utilize
spot markets in an ad hoc manner as opposed to
viewing them as an integral part of their procure-
ment strategy. The lack of quantitative decision
tools contributes to the remaining hesitation of
many buyers and sellers to participate in spot
markets. As Kaplan and Sawhney [25] rightly
note: ‘‘The matching mechanism works best when
buyers and sellers are sophisticated enough to deal
with dynamic pricing.’’ Likewise, McKinsey and
Company and CAPS Research identified the need
‘‘to determine the appropriate contract-to-spot
ratio for commodity purchases’’ in a broad survey
on the impact of B2B e
marketplaces [29].
In this paper, we address this issue and analyze
in detail optimal procurement strategies in situa-
tions where supplies can be bought both via for-
ward contracts and via spot markets. In this
context, a forward contract is an agreement to buy
a commodity at a certain future time for a certain
price. In contrast, a spot contract is an agreement
to buy (or sell) a commodity today [23]. We de-
velop mathematical models for using spot markets
for both buying and selling and we include results
for situations where the use of spot markets is
restricted to either buying or selling only. These
models enable us to analyze how spot markets
affect the optimal order quantity via forward
contract (subsequently simply referred to as con-
tract quantity), to quantify the magnitude of the
performance improvement that can be achieved by
taking optimal advantage of spot markets, and to
assess the effect of risk-averse decision making on
the optimal procurement strategy.
Our mathematical models incorporate the major
parameters of supply chains where supplies can be
bought via forward contracts and via spot mar-
kets. The results of our analysis can be used by
decision makers to determine the effect of the key
spot market characteristics on optimal contract
quantities and profits, to identify commodities for
which the use of spot markets is attractive, and to
decide how to take optimal advantage of spot
markets. To foster additional managerial insights,
we perform extensive sensitivity analyses and il-
lustrate our results with numerical examples.
This paper is organized as follows. In Section 2,
we review the relevant literature. In Section 3, we
describe our mathematical models in detail. We
characterize the optimal procurement strategy and
discuss the managerial implications of our analysis
in detail. In Section 4, we analyze the benefits of
using spot markets for buying and selling as op-
posed to not using them at all or using them for
buying or for selling only. In Section 5, we show
how the spot market parameters can be estimated
in a way consistent with our model. In Section 6,
we summarize our key findings. Mathematical
references and derivations are contained in the
Appendix.
2. Literature review
Two major lines of literature are relevant to our
research: the finance literature on commodity
pricing and hedging as well as the supply chain
management literature on dual sourcing and ca-
pacity-related supply contracting.
In the finance literature, there exists a substan-
tial amount of research on pricing and hedging
of commodity-linked contingent claims [36]. The
dominant approach is to devise equilibrium mod-
els of commodity spot prices and forward prices
that assume one or multiple exogenously given
stochastic input factors such as spot prices, con-
venience yields (defined in Section 3), or interest
rates. Gibson and Schwartz [20] developed a two-
factor model where the first factor is the spot price
of the commodity and the second factor is the
instantaneous convenience yield. Schwartz [38]
extends this model by introducing a third sto-
chastic factor, instantaneous interest rates. Mil-
tersen and Schwartz [33] further distinguish
between forward and future convenience yields
when interest rates are stochastic. These models
provide powerful tools for analyzing the term
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
structure of futures prices. However, they do not
explicitly consider demand uncertainty nor do they
allow for inventories.
A closely related stream of research that con-
siders the role of inventories employs rational
expectation models to analyze commodity price
dynamics [11,14,45]. The general focus of this re-
search is on the economic theory of storage. Most
relevant to our work is Routledge et al. [36]. They
developed a one-factor equilibrium model of for-
ward prices for commodities with Markovian net-
demand shocks as a stochastic input factor. In
their model, the spot price and convenience yield
are endogenous stochastic processes. This setup
allows Routledge et al. to show an inherent cor-
relation between spot prices and convenience
yields. In addition, they explicitly incorporate a
non-negativity constraint on inventory and dem-
onstrate that convenience yields (and therefore
spot prices) are high only if there is a shortage
of the commodity. While this research generates
valuable economic insights into the effect of in-
ventories on spot prices, the effect of spot markets
on supply chain operation is not explicitly con-
sidered.
Within the supply chain management literature
several authors have analyzed the effect of dual
sourcing on the optimal control of inventory sys-
tems. Ramasesh et al. [35] analyzed an inventory
system where companies can choose between two
supply options with different lead times. In their
model, lead times are uniformly or exponentially
distributed and demand is constant. Fong et al.
[19] extend this work and allow for normally dis-
tributed demand and Erlang distributed supplier
lead times. However, Ramasesh et al. and Fong
et al. assumed that orders for both supply options
are placed concurrently. Other researchers have
assumed sequential decision making. Rudi [37]
uses a two-stage stochastic linear programming
formulation to analyze the optimal order split
between make-to-stock and assemble-to-order.
Eeckhoudt et al. [16] consider risk aversion and
analyze general comparative-static effects of
changes in cost parameters when complementary
units can be bought after demand has been real-
ized. However, all cost parameters are assumed to
be known with certainty.
783
A recent exception that admits price and de-
mand uncertainty is an inventory control model
by Cohen and Agrawal [12]. Cohen and Agrawal
formulate and numerically solve a stochastic
dynamic program to analyze the trade-off between
long- and short-term contracts, but do not allow
for a combined use of long- and short-term con-
tracts. This combined use, however, is explicitly
considered and shown to be favorable by Araman
et al. [4] in a model developed subsequent to our
research. While Araman et al. consider a setting
similar to ours, they employ a very different set of
underlining assumptions. In particular, Araman
et al. assume that the decision-maker is strictly
risk-neutral, that the manufacturer is restricted to
buying only via the spot market (despite having
contracted additional units at a potentially much
lower price than the current spot market price),
and that spot markets are not liquid, thus, they
exhibit a pronounced (yet independent) price-
quantity effect. Closed-form results cannot be ob-
tained.
Finally, we would like to reference a substan-
tial stream of supply chain management litera-
ture that focuses on optimal capacity-related
design of supply chain contracts and analyzes the
resulting operational effects in terms of mitigating
supply risk under pre-negotiated terms. An excel-
lent classification of this literature is provided in
the recent review papers by Anupindi and Bassok
[3] and Tsay et al. [42].
In this paper, we go beyond the existing litera-
ture by explicitly analyzing the effect of spot
markets on optimal inventory control. Our model
takes into account spot price uncertainty, corre-
lation between demand and spot prices, and risk
aversion.
3. Mathematical models
The objective of our research is to analyze and
quantify the benefits of utilizing online spot mar-
kets in supply chain operations. In this section,
we develop and solve mathematical models to
explicitly characterize the optimal usage of spot
markets in the procurement of consumption
commodities. We consider supply chains with two
784 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
supply options: under option 1, the buyer uses a
forward contract with known lead time T and
fixed unit price c. Under option 2, the buyer uses a
spot market with essentially negligible lead time
but stochastic spot price s. Stochastic demand n
occurs at time T , and units purchased via both
options can be used to fill this demand.
The economics of the supply chain are as fol-
lows: sales (consumption or usage in assembly) of
the commodity translate into revenue r > c per
unit. If the company can use spot markets for
buying, demand in excess of on-hand inventory is
met at spot price s. If the company does not use
spot markets for buying, unmet demand is lost and
an additional stockout penalty cost p P 0 per unit
might be incurred. Similarly, if the company can
use spot markets for selling, excess inventory is
‘‘salvaged’’ at spot price s. Alternatively, if the
company does not use spot markets for selling,
excess inventory is salvaged at unit price v (0 6
v < c). The expected spot price for both buying or
selling at time T is ls with standard deviation rs .
The actual spot price s at time T does not depend
on the quantity traded by the firm on the spot
market.
The buyerÕs decision problem is as follows: at
time 0, the buyer must decide on the contract
quantity q. The buyer has an unbiased forecast of
the demand at time T and knows the cumulative
distribution function (c.d.f.) Fd ð
Þ with mean de-
mand ld and standard deviation rd . At time T , the
contract quantity q is delivered and demand n
occurs. If the contract quantity q is less (greater)
than the demand n, the buyer will buy n  q (sal-
vage q  n) units. An extension to our research
may assume more complex decision making in-
stances but the above description captures the es-
sential trade-offs for an initial analysis.
The buyer seeks to maximize expected profits
EPðqÞ but is generally averse to a variance of
profits VarPðqÞ. We reflect this in our model by
maximizing ZðqÞ ¼ EPðqÞ  kVarPðqÞ, with k P 0.
This form of ZðqÞ is widely used in portfolio theory
and yields mean–variance efficient outcomes [28].
Similarly, the inclusion of higher moments into
the objective function has been widely advocated
in the inventory control literature, e.g., Lau [26].
An in-depth discussion of the justification and
limitations of this approach is provided by Bar-
Shira and Finkelshtain [7], Meyer [32], and Tsiang
[43]. An alternative approach is to maximize ex-
pected utility. This approach is often used in eco-
nomics to analyze the direction of change induced
by a hypothetical shift in parameters but is less
suitable in our setting because our objective is
to characterize the optimal solution explicitly
[43].
Finally, we should note that our managerial
discussion will be focused on cases where buying
via spot markets involves a price premium in ex-
pectation, i.e., ls P c. Such a price premium is
reflective of a positive convenience yield [24,46].
Positive convenience yields are considered a fun-
damental characteristic of commodity markets for
consumption goods [27,36] and reflect the marketÕs
expectation concerning the future availability of
the commodity. The greater the possibility that
general shortages may arise during the lead time of
the forward contract, the higher the convenience
yield [23]. Thus, the convenience yield may be
thought of as the value of being able to profit
from temporary local shortages of the commodity
through ownership of the commodity [10]. As a
procurement manager at Hewlett–Packard noted:
‘‘I was delighted to find a much needed component
for assembly of one of our products at only three
times the regular market price when faced with a
supply shortage.’’
Subsequently, we will discuss a spot market
model where commodities can be both bought and
sold (Section 3.1) and we review a pure contract
sourcing model (Section 3.2) to provide for a per-
formance benchmark.
3.1. Buy and sell model
3.1.1. Model description
If supplies can be both bought and sold (BS) via
spot markets, the profit function is
þ þ
PBS ðqÞ ¼ rn  cq  sðn  qÞ þ sðq  nÞ
¼ rn  cq  sðn  qÞ;
where s denotes the spot price at time T . When
demand n exceeds the contract quantity q, we use a
spot market to procure n  q units to prevent
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
stockouts. When demand n is less than the con-
tract quantity q, we salvage q  n units of excess
inventory by selling them on spot markets at spot
BS can be computed as
price s.
Demand n and spot price s are typically posi-
BS ¼ ld þ s 2  q ðr  ls Þ: ð1Þ
tively correlated [22,27]. When spot markets are
liquid, this correlation will be due to the realized
company demand being correlated with the overall
industry demand. The industry demand governs
the spot market price while the much smaller
company-specific demand should not be subject to
BS ¼ ðr  cÞld þ
a price-quantity effect. Thus in stochastic terms,
when demand is high, the spot price is more likely
to be high than when demand is low. We explicitly
analyze such positive correlation between demand
n and spot price s by modelling ðn; sÞ as a Bivariate
Normal (BN) distribution with correlation q P 0:
BS ¼ ð1  q2 Þðr  ls Þ r2d þ r2s r2d
ðn; sÞ  BN ½ld ; ls ; r2d ; r2s ; q . While the Normal de-
mand assumption is commonplace in the supply
chain literature, the implied Normal assumption
on the spot market price is reconciled in Section 5.
(In Section 5, we show how the spot market
parameters can be efficiently estimated based on
a mean-reverting Ornstein–Uhlenbeck process,
which is consistent with Normally distributed spot
prices.)
The expected value and variance of PBS ðqÞ can
be computed as (Appendix A.1)
EPBS ðqÞ ¼ ðr  ls Þld  qrs rd þ ðls  cÞq
and
2
VarPBS ðqÞ ¼ ½ðr  ls Þ þ r2s r2d
2
þ r2s ðld  qÞ  qrs ½qrs ð3l2d  r2d Þ
þ 2rd ðr  ls Þðld  qÞ :
The expected profits are a linear function of the
contract quantity q with coefficient ðls  cÞ. Thus,
a risk-neutral buyer (indifferent about the variance
in profits) would order an infinite quantity via
forward contract whenever the expected spot price
ls at time T is higher than the contract price c. Of
course, such a procurement strategy would be
unrealistic and thus it is imperative to take into
account the variance of profits as we maximize
ZBS ðqÞ ¼ EPBS ðqÞ  kVarPBS ðqÞ, i.e., to require
BS , EP
BS , and VarP
BS are convex decreasing
k > 0.
785
3.1.2. Closed-form results
For k > 0, the resulting optimal contract
quantity q
l c rd
q
2krs rs
Using Eq. (1), we can further compute the op-
timal expected profits and the optimal variances
of profits as
2
ðls  cÞ
EP
2kr2s
rd
q ½ðr  ls Þðls  cÞ þ r2s ð2Þ
rs
and
2
VarP
ðls  cÞ2
þ  q2 r2s ð3l2d  r2d Þ: ð3Þ
4k 2 r2s
Based on Eqs. (1)–(3), we can conduct full
sensitivity analysis with respect to all major pa-
rameters of the given procurement problem. In
what follows, we analyze the effects of risk-averse
decision making, spot-price premium, spot-price
volatility, and the correlation between demand
and spot prices on the optimal contract quantity,
the optimal expected profits, and the optimal
variances of profits in detail. In the numerical ex-
periments, we used c ¼ 10, r ¼ 30, ld ¼ 100, rd ¼
25, ls ¼ 12, rs ¼ 2:5, q ¼ 0:2; and k ¼ 0:005 to
exemplify our results (unless specified otherwise).
3.1.3. Risk-averse decision making
Risk aversion in the buyerÕs decision making
towards demand and spot price variability is re-
flected in our objective function by means of fac-
tor k. The more risk-averse the buyer, the larger
the value of k. Thus, we can analyze how a more
risk-averse buyer would optimally use spot mar-
kets by analyzing the effect of an increase in k on
the optimal solution. As k increases, the optimal
contract quantity decreases (see Eq. (1)), which in
turn results in lower optimal expected profits and
lower optimal variances of profits (see Eqs. (2) and
(3)). From Eqs. (1)–(3), we can furthermore see
that q
in k.
786 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799

This implies that for very small values of k, the pend on k for q ¼ 0. Each value of k corresponds
optimal order quantity q
BS and the optimal to a tangent point with slope k to the efficient
expected profits EP
BS are very large. Thus, an es- frontier of the BS-model, i.e., to a mean-variance
sentially risk-neutral buyer would act predomi- efficient combination of expected profits EPBS ð
Þ
nately as a speculator by ordering well in excess of and variances of profits VarPBS ð
Þ. For example,
the mean demand via forward contract and betting for k ¼ 0:005 we have q
BS ¼ 132, EP
BS ¼ 2; 064,
on selling the remaining excess supplies to spot and VarP
BS ¼ 212; 806.
markets at a spot-price premium at time T . How- Finally, we can see from Eqs. (1)–(3) that the
ever, as k ! 0 the optimal variance of profits sensitivity in k exclusively depends on the spot-
VarP
BS increases even faster than the optimal price premium ðls  cÞ and the spot-price volatil-
expected profits because EP
BS contains k in the ity rs . Demand variability rd does not affect the
denominator (Eq. (2)), whereas VarP
BS contains sensitivity in k as long as all demand can be filled
k 2 in the denominator (Eq. (3)). and all excess inventory can be salvaged via spot
On the other hand, as k grows large, q
BS , EP
BS , markets.
and VarP
BS approach finite limits. Without cor-
relation between demand and spot prices, i.e., 3.1.4. Spot-price premium
q ¼ 0, the optimal contract quantity q
BS ap- Here, we analyze how the expected spot-price
proaches the mean demand ld because the buyer premium ðls  cÞ, or equivalently, the expected
seeks to minimize the use of spot markets (both for spot price ls affects the optimal solution. Without
buying and for selling) due to the inherent spot a price premium ðls ¼ cÞ, the buyer has no in-
price uncertainty. The optimal expected profits centive to speculate in the spot markets––resulting
approach ðr  cÞld , which is the maximal expected in an optimal solution which is identical to the one
revenue from commodity consumption or base- obtained for k ! 1. With a price-premium
line profits, because the buyer no longer acts as a ðls > cÞ, the optimal contract quantity q
BS , the
speculator. Similarly, the optimal variances of optimal expected profits EP
BS , and the optimal
profits approach their minimum given by ½ðr  variances of profits VarP
BS directly depend on ls .
2
ls Þ þ r2s r2d for q ¼ 0. For q > 0, q
BS , EP
BS , and The optimal contract quantity q
BS increases in
VarP
BS still approach finite limits as k grows large, ls and exceeds the mean demand because the
but the limits are lower than for q ¼ 0 (see Eqs. buyer can sell excess inventory via spot markets at
(1)–(3)). an increasing marginal contribution ðls  cÞ. The
To illustrate the above, Fig. 1 shows how the increase of q
BS is linear in ls and more pronounced
optimal contract quantity, the optimal expected the less risk-averse the buyer is (see Eq. (1)). The
profits, and the optimal variances of profits de- increase of q
BS is linear in ls because the buyer is

E BS 2,200 q*BS 250

k =0.0025
q*BS =164
200
k =0.005
2,100
q*BS =132
150

µ d= 100
2,000

k= ∞ 50
q*BS = µ d =100
1,900 0
200,000 220,000 240,000 260,000 0 0.0025 0.005 0.0075
Var BS
k

Fig. 1. Effect of k on EP
BS , VarP
BS and q
BS for q ¼ 0.
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799 787

torn between being risk averse both towards buy-
ing and towards selling via spot markets at time T .
The optimal expected profits EP
BS are de- efficient point because the buyer can not increase
creasing–increasing in the expected spot price ls .
For q > 0, we can see from Eq. (2) that EP
BS is kets.
decreasing in ls when ls 6 ðc þ qkrs rd ðr þ cÞÞ=
ð1 þ 2qkrs rd Þ and increasing in ls otherwise. EP
BS 3.1.5. Spot-price volatility
initially decreases in ls if q > 0 because buying
BS is strictly de-
complementary units via spot markets to prevent
stockouts becomes more costly. After the initial
decrease, the optimal expected profits increase in
ls and exceed the base-line profits ðr  cÞld be-
cause additional revenues can be generated by
selling excess inventory to spot markets at an in-
creasing marginal contribution ðls  cÞ. Note that
for q ¼ 0 the optimal expected profits are strictly
increasing in ls (Eq. (2)).
The optimal variance of profits VarP
BS is also contract quantity q
BS approaches the mean de-
decreasing–increasing in the expected spot price ls .
From Eq. (3), it can be shown that the optimal
variances of profits are decreasing in ls when
ls 6 ðc þ 4k 2 ð1  q2 Þr2d r2s rÞ=ð1 þ 4k 2 ð1  q2 Þr2d r2s Þ
and strictly increasing in ls otherwise. The opti-
mal variances of profits initially decrease in ls
because an increasing optimal contract quantity
provides better protection against demand vari-
ability. However, as ls increases further, VarP
BS 3.1.6. Correlation between demand and spot prices
increases because the buyer is already sufficiently
BS is strictly
protected against demand variability but becomes
increasingly exposed to the variability in spot pri-
ces when selling excess inventory.
Fig. 2 shows how the optimal contract quantity,
the optimal expected profits, and the optimal
variances of profits depend on ls for q ¼ 0. For
ls ¼ c, the efficient frontier collapses to a single
expected profits by speculating in the spot mar-
The optimal contract quantity q
creasing in spot price volatility rs when rs < ðls 
cÞ=ðqkrd ðr  ls ÞÞ and increasing in rs otherwise
(see Eq. (1)). When the variability in spot prices is
low, selling excess inventory via spot markets at
a spot-price premium is attractive. In addition, a
high contract quantity provides good protection
against demand variability. For larger values of rs ,
however, the buyer limits the use of spot markets
(both buying and selling) and, thus, the optimal
mand ld as rs ! 1 (Fig. 3).
Fig. 3 also shows how the optimal expected
profits and the optimal variances of profits depend
on rs . From Fig. 3, we can see that a reduced spot
market volatility rs improves the efficient frontier
by allowing for higher optimal expected profits
and lower optimal variances of profits.
The optimal contract quantity q
decreasing in correlation q if ls < r (see Eq. (1)).
As q increases, the contribution from selling excess
inventory via spot markets decreases because when
excess inventory is high, the spot price is more
likely to be low than when excess inventory is low

E BS 2,500 q*BS 250

200

2,250 k =0.005
µ s=12 150

µ s=11
µ d = 100
2,000
µ s=10
50

1,750 0
200,000 250,000 300,000 10 11 12 13 14
Var µs
BS

Fig. 2. Effect of ls on EP
BS , VarP
BS and q
BS for q ¼ 0.
788 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799

E BS 2,500 q*BS 250

σs=1.25 200

2,250
σ s=2.5 150 ρ =0.0
ρ =0.2
σ s=3.75 µ d = 100
2,000 ρ =0.4
50

1,750 0
200,000 250,000 300,000 0 1,25 2,5 3,75 5
σs
Var BS

Fig. 3. Effect of rs on EP
BS , VarP
BS , and q
BS .

and vice versa. Furthermore, we can see from inventory via spot markets is reduced. Thus, the
Eqs. (2) and (3) that the optimal expected profits buyer will procure more from spot markets as rd
EP
BS and the optimal variances of profits VarP

pffiffiffi BS increases in order to reduce the likelihood of excess

are strictly decreasing in q given ðrd =ld Þ < 3, a inventory. For q ¼ 0, however, the optimal con-
condition we would expect to hold in practise. tract quantity q
BS and the optimal expected profits
Fig. 4 illustrates the effect of q on the optimal EP
BS are unaffected by the demand variability rd
solution. Note that in Fig. 4, the optimal contract (see Eqs. (1) and (2)) because the optimal balance
quantity q
BS would be negative for large values of between buying and selling via spot markets is not
q because of the Normal demand assumption. In affected by rd since all demand will be filled. Fi-
these cases, we would set q
BS equal zero. nally, we can see from Eq. (3) that an increase in
demand variability rd increases the optimal vari-
3.1.7. Demand distribution ances of profits VarP
BS , as we would expect.
The optimal contract quantity q
BS and the op-
timal expected profits EP
BS are linearly increasing 3.1.8. Comments on modelling assumptions
in the mean demand ld because the company will The original stockout penalty cost p and salvage
fill all demand. For q > 0, q
BS and EP
BS are de- value outside the spot market v do not enter the
creasing in demand variability rd because the ex- BS-model because of our implicit assumption of
pected profit contribution from selling excess using the spot market exclusively. This assumption

E BS 2,500 q*BS 250

200
2,250 ρ =0.0
150

k =0.005
2,000 µ d = 100
ρ =0.4
ρ =0.2
50

1,750
100,000 150,000 200,000 250,000 300,000 0
0 0.2 0.4 0.6 0.8 1 ρ
Var BS

Fig. 4. Effect of q and k on EP

BS , VarP
BS , and q
BS .
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799 789

is conservative in that it leads to a lower bound on ent values of the stockout penalty cost p, with sal-
expected profits and to an upper bound on vari- vage value v ¼ 8 and n  Normal½ld ; r2d .
ance of profits. For completeness, we include re- The optimal contract quantity q
PC must satisfy
sults relaxing this assumption in Section 4. (Appendix A.2)
pþrc
3.2. Pure contract sourcing Fd ðqÞ ¼  2k½ðr  vÞ½1  Fd ðqÞ V1 ðqÞ
pþrv
Following our detailed analysis of the BS-  pFd ðqÞP1 ðqÞ : ð4Þ
model, we now analyze a pure contract (PC) For k ¼ 0, Eq. (4) reduces to a standard news-
sourcing model where spot markets are not used. vendor problem [34], while for k > 0, q
PC is also
The PC-model is then used as a reference point for affected by the variance of profits. We can see from
the evaluation of models that take advantage of Eq. (4) that q
PC is decreasing in k for p 6 p, p can
spot markets in Section 4. be computed by solving
The profit function for PC sourcing is   
1 p þ r  c
þ
PPC ðqÞ ¼ ðr  cÞq  ðr  vÞðq  nÞ  pðn  qÞ :
þ V1 Fd
pþrv
  
The expected value and variance of PPC ðqÞ can be pðp þ r  cÞ 1 p þ r  c
¼ P1 Fd
computed as (Appendix A.2) ðr  vÞðc  vÞ pþrv
EPPC ðqÞ ¼ ðr  cÞq  ðr  vÞV1 ðqÞ  pP1 ðqÞ and increasing in k for p > p. For p 6 p, q
PC de-
and creases in k because the buyer is risk averse to-
wards excess inventory. For p > p, q
PC increases in
VarPPC ðqÞ ¼ ðr  vÞ2 V2 ðqÞ þ p2 P2 ðqÞ k because the buyerÕs stockout aversion dominates
2
 ½ðr  vÞV1 ðqÞ þ pP1 ðqÞ : over the buyerÕs aversion towards excess inventory
[39]. In all subsequent numerical experiments, we
R q For notational convenience, we define
R1 Vn ðqÞ ¼ will use p ¼ 20, which corresponds to the profit
n n
n¼1
ðq  nÞ dFd ðnÞ and Pn ðqÞ ¼ n¼q ðn  qÞ  margin, to exemplify our results. We note p ¼ 146
dFd ðnÞ. V1 ðqÞ denotes the expected excess inventory as a reference point.
and P1 ðqÞ denotes the expected number of short-
ages if q units are at hand to satisfy demand n
(Appendix A.3). 4. Model comparison
Analogous to the BS-model, the buyer maximizes
ZPC ðqÞ ¼ EPPC ðqÞ  kVarPPC ðqÞ. Fig. 5 shows In this section, we analyze the performance
how the optimal solution depends on k for differ- improvement over the PC-model that can be

Fig. 5. Effect of k and p on EP

PC , VarP
PC , and q
PC .
790 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799

achieved by taking optimal advantage of spot cause all demands are filled in the BS-model and in
markets. We base our comparison on the optimal the BO-model. Since both the BS-model and the
contract quantity, the optimal expected profits and BO-model share this assumption, we first compare
the optimal variance of profits. Furthermore, we these two models. Then we compare the PC-model
consider the implied expected fill rate (EFR) be- and the SO-model.
cause some demands are lost in the PC-model, From Fig. 6, we can see that the BS-model
while all demands can be filled in the BS-model. strictly dominates the BO-model. The optimal ex-
To foster additional structural insights, we also pected profits in the BO-model are bounded above
include results for similar models where spot by the base-line profits ðr  cÞld (represented by
markets are either used for buying only (BO- the horizontal line in Fig. 6), while in the BS-
model) or selling only (SO-model). A full devel- model, additional revenues can be generated by
opment and sensitivity analysis of the BO-model selling excess inventory to spot markets. Both
and the SO-model are provided by Seifert [40] procurement strategies yield an EFR of 100%.
(Appendices A.4 and A.5 provide a brief reference However, the optimal contract quantities (shown
of the respective results). Table 1 summarizes the in brackets in Fig. 6) are lower in the BO-model
optimal solution and the corresponding EFR for than in the BS-model (for k constant) because
k ¼ 0:005 and q ¼ 0:2. under the BO-model excess inventory cannot be
Table 1 shows that significant profit gains can salvaged at a profit. Thus, on average the buyer
be achieved by taking full advantage of spot will buy more via forward contract (and thus, less
markets. Furthermore, the EFR is improved when via spot markets) under the BS-model than under
spot markets are used. The resulting optimal the BO-model.
variance of profits when buying via spot markets, Similarly, we can see from Fig. 6 that the SO-
however, can be higher than in the PC-model be- model strictly dominates the PC-model. The opti-
mal expected profits in the PC-model are bounded
above by the base-line profits while in the SO-
Table 1 model, additional profits can be generated by
Performance summary for k ¼ 0:005 and q ¼ 0:2 selling excess inventory to spot markets. Both
Model q
EP
VarP
EFR (%) procurement strategies yield an EFR less than
BS 96.0 1,980 197,363 100 100% and the optimal variance of profits is sig-
PC 106.8 1,695 113,697 93 nificantly lower when the EFR is low. The opti-
BO 63.1 1,911 202,963 100 mal contract quantities and the EFR (shown in
SO 112.4 1,826 104,945 95
brackets in Fig. 6) are lower in the PC-model than

Fig. 6. Comparison of spot market models.

 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799 791

in the SO-model (for k constant) because under the lustrate the model behavior we employ separate
PC-model excess inventory cannot be salvaged numerical experiments where the shortage penalty
profitably. Thus, on average, the buyer will buy cost p is varied between 0 to 10 given k ¼ 0:005
more via forward contracts under the SO-model and q ¼ 0:2. Furthermore, we use c ¼ 10; r ¼ 14;
than under the PC-model. v ¼ 6; ld ¼ 100, rd ¼ 25, ls ¼ 11, and rs ¼ 2:5
To gain additional insights into the optimal use (i.e., product data with a lower revenue figure than
of spot markets, we can complement our model originally) to allow for more pronounced sensi-
comparison by allowing the service level to be tivity of the model performance and the implied
variable in all four models. Specifically, we may service level in the shortage penalty cost p than in
relax the assumption that all demand be filled our original numerical experiment. The resulting
when buying via spot markets and assume instead model performances for the BS c d
BS-, BO-, SO-, and
BO
that units will be bought via spot markets only if PC-models are shown in Fig. 7.
the spot price s is less than the corresponding lost From Fig. 7, we can see that the BS c
BS-model
sales cost. These modified models no longer imply dominates all other models both in terms of the
a 100% expected fill rate and are subsequently re- attained EFR and the attained objective function
c and d
ferred to as BS
BS- BO-model. The profit func-
BO value Z. Furthermore, we can see that being able to
c
tion for the BS
BS-model is buy complementary units via spot markets is most
valuable when the shortage penalty cost p is high,
P b ðqÞ ¼ rn  cq  min½s; r þ p ðn  qÞþ
BS while the SO-model can be seen to perform equally
þ
þ sðq  nÞ well to the BS c
BS-model and better than the d BO-
BO
d
and the profit function for the BO-model
BO is model in terms of Z for lower values of p.
We next analyze how the optimal usages of spot
þ
Pc ðqÞ ¼ rn  cq  min½s; r þ p ðn  qÞ markets in terms of buying and selling is affected
BO
BO
þ by the spot-price premium and the spot-price
þ vðq  nÞ :
volatility. We define EPB ¼ ðP1 ðq
Þ=ld Þ  100%
The expected profit and the variance of prof- and EPS ¼ ðV1 ðq
Þ=ld Þ  100%. EPB denotes the
c and BO
its for the BS
BS- d
BO-model can be readily com- expected percentage bought via spot markets and
puted following standard definitions. As in our EPS denotes the expected percentage sold via spot
previous models, the buyer maximizes ZðqÞ ¼ markets if q units were ordered via forward con-
EPðqÞ  kVarPðqÞ but the effective service level tract to satisfy demand n. Fig. 8 shows how EPB
(or the EFR) will now depend on the given (left bar) and EPS (right bar) are affected by the
shortage penalty cost p in all four models. To il- spot-price premium and the spot-price volatility

Fig. 7. Effect of p on EFR and Z.

792 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799

Spot-Price Volatility
Low (σs=1.25) Medium (σ s=2.5) High (σs=3.75)

EPB EPS EPB EPS EPB EPS

BO 51 41 31

Low BS 17 5 25 3 22 3
(µs=11)

SO 17 16 15

Spot-Price
Premium
EPB EPS EPB EPS EPB EPS

BO 44 38 31

High
BS 0 56 12 8 16 6
(µs=12)

SO 18 17 16

Fig. 8. Effect of ls and rs on EPB and EPS.

for the BO-, BS-, and SO-model. As the spot-price
premium increases, emphasis on using spot mar-
kets shifts from buying to selling because when
expected spot prices are low, the buyer benefits
from buying via spot markets ‘‘as needed’’, while
when expected spot prices are high, the buyer gains
by selling excess inventory to spot markets at a
price premium. Furthermore, Fig. 8 shows that a
risk averse buyer under the BO-model and under
the SO-model will generally use spot markets less
(reflected by lower EPB and EPS) when the spot-
price volatility is higher. Under the BS-model,
however, an increased spot-price volatility may
increase the use of spot markets while simulta-
neously shifting emphasis on using spot markets
from selling to buying.
The above model comparison and sensitivity
analysis exemplify the results that can be obtained
with the presented mathematical models for taking
advantage of spot markets. By enabling decision-
makers to quantify the corresponding magnitude
of the performance improvements, one may indi-
rectly also assess the relative importance of addi-
tional cost factors such as membership fees, trade
commissions, etc. not currently accounted for in
our model but typically associated with sourcing
via spot markets.
5. Parameter estimation
Throughout Sections 3 and 4, we regarded the
expected spot price ls and its standard deviation rs
to be exogenously given. In this section, we show
how the expected spot price ls and its standard
deviation rs can be obtained from spot market
data in a way consistent with the presented model.
We decompose spot prices for a specific com-
modity into two elements: a general price pattern
gt that is common to a family of commodities and
a random price pattern ~st that is unique to a spe-
cific commodity. The spot price can then be ex-
pressed as st ¼ gt þ ~st .
The general price pattern gt is due to technology
diffusion and can be determined for an entire
family of commodities (e.g., DRAMs, CPUs, etc.)
over time. For example, gt could reflect an ap-
proximately linear or geometric price decline over
time, i.e., gt ¼ g0  at or gt ¼ g0 eat , with a P 0. a
can be estimated via least square linear regression
on st or lnðst Þ using historical spot prices of a
family of commodities. Fig. 9 shows an example
for the general price patterns of DRAMs over
time.
The random price pattern ~st is due to com-
modity specific supply and demand shocks and
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
US $
1000
64K 256K
100
16K
4K
logarithmic scale
10
0.1
1974 1976 1978 1980 1982
Fig. 9. General price patterns for DRAM components.
often exhibits a mean-reverting pattern where
prices fluctuate around an equilibrium level. A
price process with mean-reversion is considered a
natural choice for many commodities [10,36,38]. In
particular, commodity spot prices are frequently
represented as a mean-reverting Ornstein–Uhlen-
beck (OU) process [15], which we adopt for our
representation of ~st .
To arrive at an estimate for the expected spot
price ls and its standard deviation rs at time t þ T
(present time plus lead time), we proceed as fol-
lows:
1. Compute the trend coefficient a using a regres-
sion on historic spot prices for commodities
from the same family of commodities.
2. Compute st ¼ st  gt using trend coefficient a
and g0 ¼ s0 , where s0 denotes the first available
data point for the particular commodity.
3. Run a regression on st  st1 ¼ a þ bst1 þ et ,
where et is Gaussian noise with mean zero and
variance r2s ðT ¼ 1Þ. The result of this regression
allows us to estimate the parameters of mean-
reversion: the equilibrium level m  ¼ ða=bÞ,
the speed of reversion g ¼  lnð1 þ bÞ, and
793
64M
4M
16M
1M
1984 1986 1988 1990 1992 1994 1996 1998
Time
2
the variance r2 ¼ r2e ðlnð1 þ bÞÞ=ðð1 þ bÞ  1Þ,
where re is the standard error of the regression
analysis [15].
4. Compute gt ¼ m  þ gt , i.e., adjust gt for hav-
ing initially used g0 ¼ s0 by the equilibrium
level m .
5. The distribution of the spot price stþT condi-
tioned on st is Normal distributed with mean
ls ðt þ T j st Þ ¼ gtþT þ ðst  gt ÞegT and variance
r2s ðt þ T j st Þ ¼ ð1  e2gT Þðr2 =2gÞ [15].
Note that the speed of reversion g reflects a
restoring force directed towards gt and is of a
magnitude proportional to the distance. As a re-
sult, the variance r2s grows only initially but sta-
bilizes after some time, i.e., r2s ! ðr2 =2gÞ as T !
1 [15].
Let us consider a specific example to illus-
trate our approach. Fig. 10 shows spot prices for a
64M (8M  8) SDRAM PC66 component starting
April 1998. The lead time for forward contracts of
this component is T ¼ 3 months (¼63 business
days). First, we estimate a ¼ 0:007 using gt;i ¼
s0;i  at across multiple similar DRAM compo-
nents i. Then, we use the actual spot prices st¼0
794 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
US$ 14
12
10
6
4/1/98 6/1/98 8/1/98
Fig. 10. Daily spot prices and forecast with 90% confidence interval (Source: AICE).
through st¼200 for the 64M (8M  8) SDRAM
PC66 component (with s0 ¼ 12:35 and s200 ¼
10:29) to determine the parameters of mean re-
version: m ¼ 1:82, g ¼ 0:12, and r2 ¼ 0:19 as
well as g200 ¼ 9:15 and gtþT ¼263 ¼ 8:7. Finally, we
compute ls ð263js200 Þ ¼ 8:7 and rs ð263 j s200 Þ ¼ 0:9.
The resulting forecast, along with its 90% confi-
dence interval, is shown in Fig. 10 for t ¼ 201 to
263 (i.e., to the right of the vertical line).
Finally, we would like to point out that our
representation of spot prices is but one of
many alternatives [15,38,44]. In particular, more
elaborate models such as a geometric Ornstein–
Uhlenbeck model with drift term [31] or a
Poisson–Gaussian model of mean-reversion with
jumps [30] could be used instead. However, the
limited spot price history for most commodities is
often not sufficient to estimate the parameter for
these more complete models.
6. Conclusion
Spot markets have recently emerged for a broad
range of commodities and many companies have
started to utilize them in addition to their tradi-
tional procurement via forward contracts. In this
paper, we analyzed this development from a sup-
ply chain perspective. We developed and solved
10/1/98 12/1/98 2/1/99 4/1/99
mathematical models that determine the optimal
order quantity to purchase via traditional forward
contracts and the optimal quantity to purchase via
spot markets. We analyzed the most general situ-
ation where commodities can be both bought and
sold via a spot market. We obtained closed-form
results that enabled us to provide full sensitivity
analysis on the optimal procurement strategies. To
gain additional structural insights, we comple-
mented our research by considering situations
where we restrict the use of spot markets to buying
or selling only. These additions allowed us to
further analyze the merits of leveraging online spot
markets and to enrich the performance compari-
son versus a pure contract sourcing via traditional
forward contracts.
The approaches presented in our paper can be
used by decision makers to identify commodities
for which the use of spot markets is attractive as
well as to determine optimal procurement strate-
gies for those commodities based on some key
parameters, such as demand and spot price vola-
tilities, correlation between demand and spot pri-
ces, and risk aversion. Our analysis allows to
explicitly quantify the potential performance gains
that companies may realize by making optimal use
of online spot markets and shows that significant
profit improvements can indeed be achieved if a
moderate fraction of the commodity demand is
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799 795

procured via spot markets. Our results also show The variance of profits can be computed as
that companies who use spot markets can offer a
VarPBS ðqÞ
higher expected service level, but that they might
experience a higher variability in profits than ¼ Var½rn  sðn  qÞ
companies who do not use spot markets.
Finally, the presented model provides valuable ¼ E½Var½rn  sðn  qÞjn
insights into the required tools and capabilities
þ Var½E½rn  sðn  qÞjn
that companies will need to acquire to more fully
leverage spot markets. 2
¼ E½ðn  qÞ Var½s j n
þ Var½rn  E½s j n ðn  qÞ
Acknowledgements ¼ ð1  q2 Þr2s E½n2  2qn þ q2

The authors thank personnel at HP Trad- rs

þ Var rn  ls þ q ðn  ld Þ ðn  qÞ
ingHubs (now part of Converge) for their coop- rd
eration and feedback in conducting this research.
The authors would also like to thank Professor H. ¼ ð1  q2 Þr2s ½r2d þ ðld  qÞ2
L. Lee, Stanford University, as well as the anon-  

rs rs
ymous referees for their constructive feedback that þ Var r  ls þ q ðq þ ld Þ n  q n2
improved this paper. rd rd
2 2
¼ r2d ðr  ls Þ þ r2s ½r2d þ ðld  qÞ
Appendix A 2
 q2 r2s ½r2d þ ðld  qÞ þ 2q2 r2s ðr2d  l2d Þ

A.1. Buy and sell model  2qrd rs ld ðr  ls Þ

The profit function for buying and selling (BS)  2qrs ðqrs ld  rd ðr  ls ÞÞq þ q2 r2s q2
via spot markets is
¼ ðr  ls Þ2 r2d þ r2s ½r2d þ ðld  qÞ2  qrs
þ þ
PBS ðqÞ ¼ rn  cq  sðn  qÞ þ sðq  nÞ  ½qrs ð3l2d  r2d Þ þ 2rd ðr  ls Þðld  qÞ
¼ rn  cq  sðn  qÞ:
using
The expected profit and its derivative can be
computed as

rs rs
Var ðr  ls þ q ðq þ ld ÞÞn  q n2
EPBS ðqÞ rd rd
Z Z
1 1 ¼ Var½aX þ bX 2
¼ cq þ ½rn  ðn  qÞs fd;s ðn; sÞ ds dn  
n¼0 s¼0 rs
Z  1  with a ¼ r  ls  bðq þ ld Þ and b ¼  q
rs rd
¼ cq þ rn  ðn  qÞ½ls þ q ðn  ld Þ dFd ðnÞ
rd
n¼0
¼ r2d ½a2 þ 4abld þ b2 l2d þ 2b2 r2d
¼ ðr  ls Þld  qrs rd þ ðls  cÞq
¼ r2d ½ðr  ls Þ2 þ 2b2 ðr2d  l2d Þ þ 2bld ðr  ls Þ
and  2bðbld þ r  ls Þq þ b2 q2
2
o ¼ r2d ðr  ls Þ þ 2q2 r2s ðr2d  l2d Þ  2qrd rs ld
EPBS ðqÞ ¼ ls  c:
oq  ðr  ls Þ  2qrs ðqrs ld  rd ðr  ls ÞÞq þ q2 r2s q2
796 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799

and and
2 o
Var½aX þ bX VarPPC ðqÞ ¼ 2ðr  vÞ2 V1 ðqÞ  2p2 P1 ðqÞ
2 2 2 2 oq
¼ E½ðaX þ bX Þ  ðE½aX þ bX Þ
2  2½ðr  vÞV1 ðqÞ þ pP1 ðqÞ
¼ a2 E½X 2 þ 2abE½X 3 þ b2 E½X 4  a2 ðE½X Þ
2
 ½ðv  rÞFd ðqÞ þ p½1  Fd ðqÞ
 2abE½X E½X 2  b2 ðE½X 2 Þ
¼ 2ðp þ r  vÞ½ðr  vÞ½1  Fd ðqÞ V1 ðqÞ
¼ r2d ½a2 þ 4abld þ b2 l2d þ 2b2 r2d
 pFd ðqÞP1 ðqÞ :
given E½X ¼ ld , E½X 2 ¼ l2d þ r2d , E½X 3 ¼ l3d þ
The objective function is ZPC ðqÞ ¼ EPPC ðqÞ 
3ld r2d , and E½X 4 ¼ l4d þ 3l2d r2d þ 3r4d for X 
kVarPPC ðqÞ; setting ðoqo ÞZPC ðqÞ ¼ 0, we arrive at
Normal½ld ; r2d .
Eq. (4) which must be satisfied by the optimal
The first derivative of VarPBS ðqÞ with respect
contract quantity q
PC . For p ¼ 0, the extreme
of q is point q
PC must be a unique maximum of ZPC ðqÞ
o because Zðq j p ¼ 0Þ is concave-convex in q and
VarPBS ðqÞ ¼ 2qrs rd ðr  ls Þ  2r2s ðld  qÞ:
oq limq!1 ZPC ðqÞ ¼ 1. To show that Zðq j p ¼ 0Þ
is concave–convex in q consider EPPC ðqÞ and
The objective function is ZBS ðqÞ ¼ EPBS ðqÞ 
kVarPPC ðqÞ separately. EPPC ðqÞ is strictly
kVarPBS ðqÞ and is strictly concave in q for k > 0 2
2 concave in q because ðoo2 qÞEPPC ðqÞ < 0, and
and rs > 0 because ðoo2 qÞZBS ðqÞ ¼ 2kr2s < 0. Set-
kVarPPC  ðqÞ is concave–convex in q because
ting ðoqo ÞZBS ðqÞ ¼ 0, we arrive at Eq. (1) which must
limq!1 VarPPC ðq j p ¼ 0Þ ¼ 0, limq!1 VarPPC 
be satisfied by the unique maximum of ZBS ðqÞ, the
ðq j p ¼ 0Þ ¼ ðr  vÞ2 r2d > 0, and ðoqo ÞVarPPC 
optimal contract quantity q
BS .
ðq j p ¼ 0Þ > 0. To show that limq!1 ZPC ðqÞ ¼
1, it suffices to show that limq!1 EPPC ðqÞ ¼
A.2. Pure contract sourcing
1 because kVarPPC ðqÞ 6 0; 8q. This can be
shown directly, i.e., limq!1 EPPC ðqÞ ¼ ðr  vÞ 
The profit function for pure contract (PC)
ld  ðc  vÞ limq!1 q ¼ 1 and limq!1 EPPC 
sourcing is
ðqÞ ¼ pld þ ðp þ r  cÞ limq!1 q ¼ 1 given
þ þ
PPC ðqÞ ¼ r min½n; q  cq þ vðq  nÞ  pðn  qÞ v < c < r and p P 0. For p > 0, limq!1 ZðqÞ ¼
1 continues to hold, but we have to rely on
¼ ðr  cÞq  ðr  vÞðq  nÞþ  pðn  qÞþ :
numerical analysis to support our conjecture that
ZPC ðqÞ is unimode.
The expected profit and its derivative can be
computed as
A.3. Mathematical references
EPPC ðqÞ ¼ ðr  cÞq  ðr  vÞV1 ðqÞ  pP1 ðqÞ Rq n
and R 1Let Vn ðqÞn ¼ n¼1 ðq  nÞ dFd ðnÞ and Pn ðqÞ ¼
n¼q
ðn  qÞ dFd ðnÞ. Notice that ðo=oqVn ðqÞÞ ¼
o nVn1 ðqÞ and ðo=oqPn ðqÞÞ ¼ nPn1 ðqÞ while
EPPC ðqÞ ¼ p þ r  c  ðp þ r  vÞFd ðqÞ:
oq V0 ðqÞ ¼ Fd ðqÞ and P0 ðqÞ ¼ 1  Fd ðqÞ.
The variance of profits and its derivative can be For Fd ð
Þ  Normal½ld ; r2dR , we have fd0 ðqÞ ¼
q
computed as ððq  ld Þ=r2d Þfd ðqÞ and n¼1
n dFd ðnÞ ¼ ld 
2
Fd ðqÞ  rd fd ðqÞ (adapted from [17]). Thus, V1 ðqÞ
VarPPC ðqÞ ¼ E½ððr  vÞðq  nÞþ þ pðn  qÞþ Þ2 and P1 ðqÞ can be computed as V1 ðqÞ ¼ ðq  ld Þ
Fd ðqÞ þ r2d fd ðqÞ and P1 ðqÞ ¼ ðld  qÞ½1  Fd ðqÞ þ
 ðE½ðr  vÞðq  nÞþ þ pðn  qÞþ Þ2 r2d fd ðqÞ.
2
¼ ðr  vÞ V2 ðqÞ þ p2 P2 ðqÞ Finally, for ðn; sÞ  BN½ld ; ls ; r2d ; r2s ; q with cor-
relation q, we repeatedly use E½s j n ¼ ls þ qðrs =
2
 ½ðr  vÞV1 ðqÞ þ pP1 ðqÞ rd Þðn  ld Þ and Var½s j n ¼ ð1  q2 Þr2s [5].
 R.W. Seifert et al. / European Journal of Operational Research 152 (2004) 781–799
A.4. Spot markets used for buying only
If the use of spot markets is restricted to buying
only (BO), the profit function is
þ þ
PBO ðqÞ ¼ rn  cq  sðn  qÞ þ vðq  nÞ
¼ ðr  cÞq þ ðr  sÞðn  qÞ þ q, the buyer incurs a stockout penalty cost p P 0
þ
þ ðv  rÞðq  nÞ :
When demand n exceeds the contract quantity
q, we use a spot market to procure n  q units to
prevent stockouts. When demand n is less than the
contract quantity q, we salvage q  n units of ex-
cess inventory by selling them outside the spot
market at unit price v. As in the BS-model, de-
mand n and spot price s are Bivariate Normal
distributed: ðn; sÞ  BN ½ld ; ls ; r2d ; r2s ; q .
The expected value and variance of PBO ðqÞ can
be computed as [40]
EPBO ðqÞ ¼ ðr  cÞq þ ðv  rÞV1 ðqÞ þ uP1 ðqÞ
þ
þ wE½ðn  qÞ n
and
VarPBO ðqÞ ¼ ðr2s  w2 r2d þ u2 ÞP2 ðqÞ
2
þ ðv  rÞ V2 ðqÞ
þ 2
þ wE½ð2un þ wn2 Þ½ðn  qÞ As in our previous models, the buyer maximizes
 ðuP1 ðqÞ þ ðv  rÞV1 ðqÞ
þ wE½ðn  qÞ n Þ ;
þ 2
SO , however, cannot be derived in
where
u ¼ r  ls þ qðrs =rd Þld > 0 and w ¼ qðrs =rd Þ:
As in our previous models, the buyer maxi-
mizes ZBO ðqÞ ¼ EPBO ðqÞ  kVarPBO ðqÞ. The opti-
mal contract quantity q
BO , however, cannot be [1] AMR Research, Inc. Independent Trading Exchanges––
derived in closed-form and numerical analysis is
needed to conduct sensitivity analysis as detailed
in Seifert [40].
A.5. Spot markets used for selling only
If the use of spot markets is restricted to selling
only (SO), the profit function is
797
þ þ
PSO ðqÞ ¼ rn  rðn  qÞ  cq þ sðq  nÞ
þ
 pðn  qÞ
þ þ
¼ ðr  cÞq þ ðs  rÞðq  nÞ  pðn  qÞ :
When demand n exceeds the contract quantity
per unit. When demand n is less than the contract
quantity q, we salvage q  n units of excess in-
ventory by selling them on spot markets at spot
price s. As in the BS-model, demand n and spot
price s are Bivariate Normal distributed: ðn; sÞ 
BN½ld ; ls ; r2d ; r2s ; q .
The expected value and variance of PSO ðqÞ can
be computed as [40]
EPSO ðqÞ ¼ ðr  cÞq  uV1 ðqÞ  pP1 ðqÞ
þ
 wE½ðq  nÞ n
and
VarPSO ðqÞ ¼ ðr2s  w2 r2d þ u2 ÞV2 ðqÞ þ p2 P2 ðqÞ
þ wE½ð2un þ wn2 Þ½ðq  nÞþ 2
 ðuV1 ðqÞ þ pP1 ðqÞ
þ wE½ðq  nÞþ n Þ2
where
u ¼ r  ls þ qðrs =rd Þld and w ¼ qðrs =rd Þ:
ZSO ðqÞ ¼ EPSO ðqÞ  kVarPSO ðqÞ. The optimal con-
tract quantity q
closed-form and numerical analysis is needed to
conduct sensitivity analysis as detailed in Seifert
[40].
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