Question

Handi Inc., a cell phone manufacturer, procures a standard display from LCD Inc. via an options contract. At the start of quarter 1 (Q1), Handi pays LCD $4.50 per option. At that time, Handi’s forecast of demand in Q2 is normally distributed with mean 24,000 and standard deviation 8,000. At the start of Q2, Handi learns exact demand for Q2 and then exercises options at the fee of $3.50 per option, (for every exercised option, LCD delivers one display to Handi). Assume Handi starts Q2 with no display inventory and displays owned at the end of Q2 are worthless. Should Handi’s demand in Q2 be larger than the number of options held, Handi purchases additional displays on the spot market for $9 per unit. For example, suppose Handi purchases 30,000 options at the start of Q1, but at the start of Q2 Handi realizes that demand will be 35,000 units. Then Handi exercises all of its options and purchases 5,000 additional units on the spot market. If, on the other hand, Handi realizes demand is only 27,000 units, then Handi merely exercises 27,000 options.

Answer 1

The question revolves around Handi Inc.'s use of options contracts with LCD Inc. to manage inventory based on forecasted demand for cell phone displays. The contract allows Handi to adapt to actual demand in Q2, purchasing the necessary units at a set price or acquiring additional units from the spot market if needed.

Step-by-step explanation:

The scenario described involves a company named Handi Inc. that manufactures cell phones and enters into an options contract with LCD Inc. for display components. Handi is trying to manage its supply chain efficiently by using an options contract to mitigate risk associated with demand uncertainty for the upcoming quarter. The information provided suggests a focus on the principles of supply and demand, as well as the use of options contracts in business operations to manage inventory levels and reduce risk.

In the given example, if Handi purchases fewer options than the actual demand, it must secure additional displays from the spot market at a higher price. If demand is lower than expected, only the required number of options will be exercised. The objective of using options in this case is to avoid overstocking inventory, which would result in a loss since the display components are worthless at the end of Q2. This explains how options contracts can serve as a risk management tool in uncertain supply and demand environments.