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Real Options in Material Procurement Contracts

Principal Investigators Hans Bjornsson and Samuel Chiu
Ph.D. Student Francis Ng
Project Sponsor CIFE
Project Date 10/1/01
Description Much "management" research in the construction industry has been on facility and project design/management - dealing with the "physics" of construction management. We believe that the time has come to focus research on the information and finance side of construction management, which will provide huge payoff for the industry. This research proposal defines a project that will examine how real options could be constructed in material procurement contracts in the construction industry. The optimal policy of how (if and when) to exercise the real options can then be turned into supply chain decision support software. Real options can provide buyers with valuable operating flexibility to minimize inventory cost and price volatility. It can also help suppliers diversify their price risks and smooth out production schedule. Therefore, this concept has a large potential in the construction industry to increase profit margin for many parties along the supply chain by minimizing wastes and increasing efficiency. Similar concepts have been applied to the semiconductor industry in production capacity reservation contracts of foundries. We identify three major problems that would have to be overcome: 1) Identify the types of materials and the types of real options to embed into the procurement contracts of these materials. 2) Reduce the number of dimensions/state variables in dynamic programming to make calculation feasible. 3) Propose incentives for buyers and sellers to change the current way of doing business. We believe that 1) can be solved by conducting surveys of contractors, owners, distributors and manufacturers and numerical modeling using historical data; 2) through clever formulation of the temporal decision problem to reduce problem dimension and to de-couple separable components; and 3) through working with buyers and suppliers on real contracts to identify the correct incentives.
Progress Report

In 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.

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Working Papers

Abstract: Evaluating Price Flexibility in Material Procurement

This 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.

Publications Seed Proposal
Presentations Project Presentation