A Contingent-Claims Approach to the Inventory-Stocking Decision

Abstract

The contingent-claims approach associates the demand for an inventory item with an underlying state variable. We map the payoffs from an inventory policy onto this variable, construct a portfolio of options that replicates these inventory payoffs, and then derive the value of an inventory policy using option-pricing models. This approach views inventory as an option on future sales. The paper reevaluates some of the basic inventory problems and shows how these problems can be solved with economically sound pricing models. The paper shows that the tools of financial economics can be used to make basic decisions in inventory management.

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