Risk Management in Long-Term Contracts
10 Pages Posted: 20 Sep 2005
Date Written: September 2005
Long-term contracts are designed to manage risk. After a brief discussion of why it is unhelpful to invoke risk aversion for analyzing serious commercial transactions between sophisticated entities, this paper focuses on adaptation to changed circumstances. In particular, it considers the options to abandon and the discretion to change quantity. It then analyzes a poorly designed contract between Alcoa and Essex showing how the parties misframed their problem and designed a long-term contract that was doomed to fail.
JEL Classification: K3
Suggested Citation: Suggested Citation