Mean-variance trade-offs in supply contracts

We study the trade-offs faced by a manufacturer signing a portfolio of long-term contracts with its suppliers and having access to a spot market. The manufacturer incurs inventory risk when purchasing too many contracts and spot price risk when buying too few. We quantify these risks for a single selling period by studying the profit mean and variance for a given portfolio of option contracts. We characterize the set of efficient portfolios that the manufacturer must hold in order to obtain dominating mean-variance pairs. Among these, we emphasize the maximum expectation portfolio, obtained by solving the classical newsvendor problem, and the corresponding minimum variance portfolio. We show that the upper-level sets of a mean-variance utility function are connected. Hence, a greedy method will find the portfolios on the efficient frontier. Finally, we provide a comparison with standard hedging strategies and show that the approximation associated with financial hedging can be relatively inaccurate. (C) 2006 Wiley Periodicals, Inc.