the autumn quarter, after consulting with several project
managers and distributors, we have identified interior
doors as the material to be investigated because of
it is a generic commodity material with significant
price volatility. We have also identified long term
contract with price cap as the real option to investigate.
We then use the correlation pricing formula and dynamic
programming to find out the value of the real option
to a local door subcontractor/distributor.
Progress Report (PDF) >>
Evaluating Price Flexibility in Material Procurement
paper extends theories in finance and economics to evaluate
the cost savings of a long-term contract with price
cap versus spot purchases in construction material procurement.
In construction, material procurements are usually short-term
project based and price volatility can be up to 30%.
These and the competitive nature of the industry lead
to low profit margin of general contractors. Our rationale
is that although general contractors rely on subcontractors
to purchase most materials, they do purchase a stable
amount of commodity materials such as concrete, structural
steel, and lumber throughout the year. For contractors,
the price cap reduces price volatility of materials
without quantity requirement as they still order after
they have won a project; for
suppliers, the contracts give them steady demand and
a bigger market share. 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. This is a more accurate model
in terms of variance than simple time series analysis.
Our methodology does not require market completeness
and uses some of the latest research in finance the
projection pricing, correlation pricing, option pricing,
zero level pricing, trading with asymmetric information
as well as some lattice techniques. We also model how
a supplier can minimize her risk through hedging and
solve for the contractors optimal ordering policy.