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Quantifying Price Flexibility In Material Procurement as a Real Option

TitleQuantifying Price Flexibility In Material Procurement as a Real Option
Publication TypeTechnical Report
Year of Publication2002
AuthorsNg, F, Chiu, S, Bjornsson, H
IssueTR142
Date Published10/2002
PublisherCIFE
Publication Languageeng
KeywordsCenter for Integrated Facility Engineering, CIFE, Finance, Material Procurement, Ordering Policy, Pricing, Real Option, Stanford University
AbstractThis 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.
URLhttps://purl.stanford.edu/dx368jn4882
PDF Linkhttps://stacks.stanford.edu/file/druid:dx368jn4882/TR142.pdf
Citation Key852