Evaluating a Real Option in Material Procurement

This paper describes how to evaluate a long-term fixed priced material procurement contract versus spot purchases. We model the long-term contract as a real option. In the financial world, option pricing is based on the assumption that the market is complete and frictionless. This assumption is usually too strong when it comes to pricing real options. For example, both the option and its underlying asset are not traded in an efficient market. Our methodology does not require market completeness and uses some of the latest research in finance such as projection pricing [4], correlation pricing[5], zero level pricing, the Ratio Theorem [3] as well as some lattice techniques [2]. The option results in significant cost savings due to the ability to change order sizes while keeping price fixed. Introduction We believe that the time has come to focus research on the information and finance side of construction management. Since the seminal work of Black and Scholes in 1973 in pricing options, the financial market of options and derivatives has been growing exponentially, providing numerous ways for individuals and corporations to hedge risks and improve the performance of their portfolios. An option is valuable because it provides flexibility; it is the right but not the obligation to buy (or sell) an asset under specified terms. However, straight application of option pricing to non-financial assets is problematic because most option pricing formulae assume the options and their underlying assets are frequently traded in efficient and complete markets such as NYSE. Non-traded assets are called real assets and options on real assets are called real options. In the past ten years, there has been a lot of fruitful research in evaluating real options in oil drilling, software development and semiconductor facility planning [1]. The main effort has been to go around the strong assumption of a frictionless and complete market. We believe real options can bring great value to the construction industry by quantifying the value of managerial flexibility. For example, a contractor solicits take-offs (quotes) from suppliers for his bid preparation but does not place an order until the developer awards the contract. Therefore, his orders are usually short-term project based and are subject to fluctuation in price. This and the competitive nature of the industry lead to extremely low profit margin of contractors, typically less than 5%, which is lower than the return of risk free treasury bonds during most of the 90’s. In this paper, we focus on materials purchased by large door subcontractors who have the volume to realize the value introduced by real