Quantifying Price Flexibility In Material Procurement as a Real Option

TitleQuantifying Price Flexibility In Material Procurement as a Real Option
Publication TypeTechnical Report
AuthorsNg, F., S. Chiu, and H. Bjornsson
Date Published10/2002

This paper extends theories in finance and economics to compare the cost of a long-term contract with a price cap to that of spot purchases in construction material procurement. In construction, material procurements are usually short-term, project-based, and have a price volatility of up to 30%. These characteristics and the competitive nature of the industry lower the profit margin of general contractors. We have observed that contractors purchase a stable amount of commodity materials such as concrete, structural steel, and lumber throughout the year. For contractors, the price cap reduces the price volatility of materials without their being obliged to a quantity; for suppliers, the contracts give them steady demand and a bigger market share. We evaluate this contract as a real option and solve for the contractors optimal ordering policy. The challenge is to model price processes when materials are not frequently traded. We model price processes by using as much market information as possible and then evaluate the idiosyncratic uncertainties in a risk-neutral setting. Our methodology does not require market completeness and incorporates some of the latest research in finance such as correlation pricing, option pricing, and zero level pricing, as well as Monte Carlo simulation.

KeywordsFinance, Material Procurement, Ordering Policy, Pricing, Real Option
Year of Publication2002
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Last modified Tue, 22 Mar, 2011 at 16:41