Optimal Inventory Strategy Under Risk: A Contingent Claims Approach

Abstract

Inventory management in the agriculture industry involves many sources of risk in terms of demand uncertainty as well as uncertain margins. Divulging an optimal inventory strategy can prove cumbersome to logistics managers. In this thesis, inventory is viewed as a real option on the ability to operate. Contingent claims inventory (CCI) analysis, paired with stochastic binomial real option valuation, provides a model which values the real option embedded in holding inventory and iterates the purchasing strategy until expected profit is maximized. This framework is applied to three industry cases pertaining to: wheat flour milling, fertilizer merchandising, and bulk shipments via primary rail contracts.