The computer chip manufacturing industry

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The computer chip manufacturing industry is highly dynamic and complex. This case examines how Intel has exercised real options to help minimize its risk exposure. It has found a way to create future contracts with its equipment suppliers and has the opportunity to exercise purchase options at a date closer to when it might actually have to use the equipment.

Intel has used a real options approach to reduce its risk. In the computer chip industry, forecasting is extremely difficult and equipment is very expensive. By using real options, Intel has been able to mitigate a certain level of risk while still capitalizing on the opportunities it identifies as most promising.

Read the case below and answer the questions that follow.

The semiconductor business is complex and dynamic. This makes it very difficult to manage. On the one hand, both the technology in the chips and the consumer demand for chips are highly volatile. This makes planning for the future as far as chip designs and the production plants needs difficult. On the other hand, it is incredibly expensive to build new chip plants, about $5 billion each, and chip manufacturing equipment needs to be ordered well ahead of when it is needed. The lead time for ordering new equipment can be up to three years. This creates a great challenge. Firms have to decide how much and what type of equipment to purchase long before they have a good handle on what the demand for semiconductor chips will be. Guessing wrong leaves the firm with too much or too little capacity.

Intel has figured out a way to limit the risk it faces by using option contracts. Intel pays an up-front fee for the right to purchase key pieces of equipment at a specific future date. At that point, Intel either purchases the equipment or releases the supplier from the contract. In these cases, the supplier is then free to sell the equipment to someone else. This all seems fairly simple. A number of commodities, such as wheat and sugar, have robust option markets. The challenge isn’t in setting up the contracts; it is in pricing those contracts. Unlike wheat and sugar, where a large number of suppliers and buyers results in a robust market that sets the prices of standard commodity products, there are few buyers and suppliers of chip manufacturing equipment. Further, the equipment is not a standard commodity. As a result, prices for equipment options are the outcome of difficult negotiations.

Karl Kempf, a mathematician with Intel, has figured out how to make this process go more smoothly. Along with a group of mathematicians at Stanford, Kempf has developed a computing logic for calculating the price of options. He and his colleagues created a forecasting model for potential demand. They calculate the likelihood of a range of potential demand levels. They also set up a computer simulation of a production plant. They then use the possible demand levels to predict how many pieces of production equipment they will need in the plant to meet the demand. They run this over and over again, thousands of times, to generate predictions about the likelihood they will need to purchase a specific piece of equipment. They use this information to identify what equipment they definitely need to order. Where there is significant uncertainty about the need for equipment, they use the simulation results to identify the specific equipment for which they need option contracts and the value of those options to Intel. This helps with the pricing.

Intel estimates that since 2008, the use of options in equipment purchases has saved the firm in excess of $125 million and provided the firm with at least $2 billion in revenue upside for expansions it could have quickly made using optioned equipment.

Sources: Kempf, K., Erhun, F., Hertzler, E., Rosenberg, T., & Peng, C. 2013. Optimizing capital investment decisions at Intel Corporation, Interfaces, 43(1): 62-78; and King, I. 2012. A chipmaker’s model mathematician. Bloomberg Businessweek, June 4: 35.

How has Intel limited its risk by using options contracts?

 

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