Applicability of Financial Derivatives for Hedging Material Price Risk in Highway Construction
Publication: Journal of Construction Engineering and Management
Volume 145, Issue 5
Abstract
Highway infrastructure is critical to the sustainable development of a country. Nonetheless, these capital-intensive projects, especially in build-operate-transfer (BOT) contracts, are prone to the risk of material price fluctuations during the construction phase, which may lead to project cost overruns. To surmount the effects of downside exposures, construction companies seek innovative risk management tools. The main intention of the present study is to show how the construction industry can take advantage of well-developed financial derivatives. In particular, a new methodology is presented for hedging the material price risk using the Bermudan collar option, the applicability of which is shown via a worked example. It was found that these over-the-counter (OTC) options are appropriate risk management instruments, which conforms to the characteristics of highway construction. It is also concluded that in choosing their hedging strategy, companies should have due regard to the specific size, time frame, and counterparty credit risk.
Get full access to this article
View all available purchase options and get full access to this article.
Data Availability Statement
All data generated or analyzed during the study are included in the published paper. Information about the Journal’s data-sharing policy can be found here: http://ascelibrary.org/doi/10.1061/(ASCE)CO.1943-7862.0001263.
References
ASTM. 2016. Standard practice for preparation of asphalt mixture specimens using marshall apparatus. ASTM D6926. West Conshohocken, PA: ASTM.
ASTM. 2018. Standard terminology relating to materials for roads and pavements. ASTM D8-18. West Conshohocken, PA: ASTM.
Alkebäck, P., N. Hagelin, and B. Pramborg. 2006. “Derivative usage by non-financial firms in Sweden 1996 and 2003: What has changed?” Managerial Finance 32 (2): 101–114. https://doi.org/10.1108/0307435061064189.
Argus. 2014. Global bitumen demand and pricing. Cape Town, South Africa: Argus Media Ltd.
Ashuri, B., H. Kashani, K. R. Molenaar, S. Lee, and J. Lu. 2012. “Risk-neutral pricing approach for evaluating BOT highway projects with government minimum revenue guarantee options.” J. Constr. Eng. Manage. 138 (4): 545–557. https://doi.org/10.1061/(ASCE)CO.1943-7862.0000447.
Askar, M. M., and A. A. Gab-Allah. 2002. “Problems facing parties involved in build, operate, and transport projects in Egypt.” J. Manage. Eng. 18 (4): 173–178. https://doi.org/10.1061/(ASCE)0742-597X(2002)18:4(173).
Bank for International Settlements. 2017. OTC derivatives statistics at end-June 2017. Basel, Switzerland: Bank for International Settlements.
Bartram, S. M., G. W. Brown, and F. R. Fehle. 2009. “International evidence on financial derivatives usage.” In Financial management, 185–206. New York: Wiley.
Basel Committee on Banking Supervision. 2011. Basel III: A global regulatory framework for more resilient banks and banking systems. Basel, Switzerland: Bank for International Settlements.
Bodnar, G. M., and G. Gebhardt. 1999. “Derivatives usage in risk management by US and German non-financial firms: A comparative survey.” J. Int. Financial Manage. Account. 10 (3): 153–187. https://doi.org/10.1111/1467-646X.00049.
Cao, Y., B. Ashuri, and M. Baek. 2018. “Prediction of unit price bids of resurfacing highway projects through ensemble machine learning.” J. Comput. Civ. Eng. 32 (5): 1–10. https://doi.org/10.1061/(ASCE)CP.1943-5487.0000788.
Carter, D. A., D. A. Rogers, and B. J. Simkins. 2006. “Hedging and value in the U.S. airline industry.” J. Appl. Corporate Finance 18 (4): 21–33. https://doi.org/10.1111/j.1745-6622.2006.00107.x.
Chen, J. H., S. C. Hsu, Y. Luo, and M. J. Skibniewski. 2012. “Knowledge management for risk hedging by construction material suppliers.” J. Manage. Eng. 28 (3): 273–280. https://doi.org/10.1061/(ASCE)ME.1943-5479.0000111.
Chen, J.-H., S.-C. Hsu, R. Wang, and H.-A. Chou. 2017. “Improving hedging decisions for financial risks of construction material suppliers using grey system theory.” J. Manage. Eng. 33 (4): 04017016. https://doi.org/10.1061/(ASCE)ME.1943-5479.0000531.
Chen, J. H., L. R. Yang, M. C. Su, and J. Z. Lin. 2010. “A rule extraction based approach in predicting derivative use for financial risk hedging by construction companies.” Expert Syst. Appl. 37 (9): 6510–6514. https://doi.org/10.1016/j.eswa.2010.02.135.
Cheng, G., and C. G. Wilmot. 2009. “Louisiana highway construction cost trend after Hurricanes Katrina and Rita.” J. Constr. Eng. Manage. 135 (7): 594–600. https://doi.org/10.1061/(ASCE)CO.1943-7862.0000015.
Cherubini, U. 2013. “Credit valuation adjustment and wrong way risk.” Quant. Finance Lett. 1 (1): 9–15. https://doi.org/10.1080/21649502.2013.808029.
Chiara, N., M. J. Garvin, and J. Vecer. 2007. “Valuing simple multiple-exercise real options in infrastructure projects.” J. Infrastruct. Syst. 13 (2): 97–104. https://doi.org/10.1061/(ASCE)1076-0342(2007)13:2(97).
Cox, J. C., S. A. Ross, and M. Rubinstein. 1979. “Option pricing: A simplified approach.” J. Financial Econ. 7 (3): 229–263. https://doi.org/10.1016/0304-405X(79)90015-1.
Dafir, S. M., and V. N. Gajjala. 2016. Fuel hedging and risk management. Strategies for airlines, shippers, and other consumers. Bognor Regis, UK: Wiley.
Deloitte. 2014. “OTC derivartives: The new cost of trading.” Accessed October 10, 2018. https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/financial-services/deloitte-uk-fs-otc-derivatives-april-14.pdf.
Dubois, F., and T. Lelièvre. 2004. “Efficient pricing of Asian options by the PDE approach.” J. Comput. Finance 8 (2): 55–63. https://doi.org/10.21314/JCF.2005.138.
Duffie, D., and H. R. Richardson. 1991. “Mean-variance hedging in continuous time.” Ann. Appl. Probab. 1 (1): 1–15. https://doi.org/10.1214/aoap/1177005978.
El-Sayegh, S. M., and M. H. Mansour. 2015. “Risk assessment and allocation in highway construction projects in the UAE.” J. Manage. Eng. 31 (6): 04015004. https://doi.org/10.1061/(ASCE)ME.1943-5479.0000365.
ENR (Engineering News-Record). 2015. “The 2015 top 250 International Contractors.” Accessed October 1, 2017. https://www.enr.com/toplists/2015_Top_250_International_Contractors1.
Esfahanipour, A., and Z. Shahrokhshahi. 2013. “Project economic valuation using Asian real option approach.” Int. J. Ind. Eng. Prod. Manage. 24 (3): 339–347.
Gatti, S. 2013. Project finance in theory and practice: Designing, structuring, and financing private and public projects. Cambridge, MA: Academic.
Geltner, D., N. Miller, J. Claytion, and P. Eichholtz. 2010. Commercial real estate: Analysis & investments. Mason, OH: OnCourse Learning.
Gerner, M., and E. Ronn. 2013. “Fine-tuning a corporate hedging portfolio: The case of an airline.” J. Appl. Corporate Finance 25 (4): 74–86.
Grimsey, D., and M. K. Lewis. 2002. “Evaluating the risks of public private partnerships for infrastructure projects.” Int. J. Project Manage. 20 (2): 107–118. https://doi.org/10.1016/S0263-7863(00)00040-5.
Hanaoka, S., and H. P. Palapus. 2012. “Reasonable concession period for build-operate-transfer road projects in the Philippines.” Int. J. Project Manage. 30 (8): 938–949. https://doi.org/10.1016/j.ijproman.2012.02.001.
Heravi, G., and Z. Hajihosseini. 2012. “Risk allocation in public-private partnership infrastructure projects in developing countries: Case study of the Tehran-Chalus Toll Road.” J. Infrastruct. Syst. 18 (3): 210–217. https://doi.org/10.1061/(ASCE)IS.1943-555X.0000090.
Herbsman, Z. 1983. “Long-range forecasting highway construction costs.” J. Constr. Eng. Manage. 109 (4): 423–434. https://doi.org/10.1061/(ASCE)0733-9364(1983)109:4(423).
Hull, J. C. 2015. Options, futures and other derivatives. Boston: Pearson.
Hull, J., and A. White. 2013. “LIBOR vs. OIS: The derivatives discounting dilemma.” J. Investment Manage. 11 (3): 14–27. https://doi.org/10.2139/ssrn.2211800..
Ilbeigi, M., B. Ashuri, and Y. Hui. 2014a. “A stochastic process to model the fluctuations of asphalt cement price.” In Proc., Construction Research Congress 2014, 1111–1118. Reston, VA: ASCE.
Ilbeigi, M., B. Ashuri, and S. Shayegh. 2014b. “Empirical study of effects of price adjustment clauses (PACs) on highway construction Bid.” In Proc., Construction Research Congress 2014, 1093–1102. Reston, VA: ASCE.
Ilbeigi, M., B. Ashuri, and S. Shayegh. 2016. “Price adjustment clauses and submitted bid prices for major asphalt line items in highway projects.” J. Constr. Eng. Manage. 142 (5): 04015103. https://doi.org/10.1061/(ASCE)CO.1943-7862.0001097.
Ilbeigi, M., D. Castro-Lacouture, and A. Joukar. 2017. “Generalized autoregressive conditional heteroscedasticity model to quantify and forecast uncertainty in the price of asphalt cement.” J. Manage. Eng. 33 (5): 04017026. https://doi.org/10.1061/(ASCE)ME.1943-5479.0000537.
Interactive Brokers. 2018. “Commissions.” Accessed October 1, 2017. https://interactivebrokers.com/en/index.php?f=1590&p=options.
Iyer, K. C., and M. Sagheer. 2010. “Hierarchical structuring of PPP risks using interpretative structural modeling.” J. Constr. Eng. Manage. 136 (2): 151–159. https://doi.org/10.1061/(ASCE)CO.1943-7862.0000127.
Jeong, J., C. Ji, T. Hong, and H. S. Park. 2016. “Model for evaluating the financial viability of the BOT project for highway service areas in South Korea.” J. Manage. Eng. 32 (2): 04015036. https://doi.org/10.1061/(ASCE)ME.1943-5479.0000396.
Kaliba, C., M. Muya, and K. Mumba. 2009. “Cost escalation and schedule delays in road construction projects in Zambia.” Int. J. Project Manage. 27 (5): 522–531. https://doi.org/10.1016/j.ijproman.2008.07.003.
Kumaraswamy, M. M., and X. Q. Zhang. 2001. “Governmental role in BOT-led infrastructure development.” Int. J. Project Manage. 19 (4): 195–205. https://doi.org/10.1016/S0263-7863(99)00069-1.
Lin, J., and J. Liang. 2007. “Pricing of perpetual American and Bermudan options by binomial tree method.” Front. Math. China 2 (2): 243–256. https://doi.org/10.1007/s11464-007-0017-2.
Liu, J., X. Yu, and C. Y. J. Cheah. 2014. “Evaluation of restrictive competition in PPP projects using real option approach.” Int. J. Project Manage. 32 (3): 473–481. https://doi.org/10.1016/j.ijproman.2013.07.007.
Luenberger, D. 1998. Investment science. New York: Oxford University Press.
Mehrdoust, F., and N. Saber. 2015. “Pricing arithmetic Asian option under a two-factor stochastic volatility model with jumps.” J. Stat. Comput. Simul. 85 (18): 3811–3819. https://doi.org/10.1080/00949655.2015.1046072.
Mercatus. 2014. “The state of airline fuel hedging and risk management.” Accessed October 1, 2017. https://www.mercatusenergy.com/state-of-airline-fuel-hedging/.
Moynihan, G. P., and M. A. Al-Zarrad. 2015. “Application of hedging principles to materials price risk mitigation in construction projects.” Int. J. Constr. Eng. Manage. 4 (5): 180–190. https://doi.org/10.5923/j.ijcem.20150405.03.
Ng, A., and M. Loosemore. 2007. “Risk allocation in the private provision of public infrastructure.” Int. J. Project Manage. 25 (1): 66–76. https://doi.org/10.1016/j.ijproman.2006.06.005.
Ng, F. P., H. C. Björnsson, and S. S. Chiu. 2004. “Valuing a price cap contract for material procurement as a real option.” Constr. Manage. Econ. 22 (2): 141–150. https://doi.org/10.1080/0144619042000201349.
Nguyen, H., and R. Faff. 2002. “On the determinants of derivative usage by Australian companies.” Aust. J. Manage. (Univ. New South Wales) 27 (1): 1–24. https://doi.org/10.1177/031289620202700101.
Nguyen, D. A., M. J. Garvin, and E. E. Gonzalez. 2018. “Risk allocation in U.S. Public-private partnership highway project contracts.” J. Constr. Eng. Manage. 144 (5): 04018017. https://doi.org/10.1061/(ASCE)CO.1943-7862.0001465.
NYMEX (New York Mercantile Exchange). 2017. “Crude oil futures quotes.” Accessed October 1, 2017. https://www.cmegroup.com.
Postali, F. A. S., and P. Picchetti. 2006. “Geometric Brownian motion and structural breaks in oil prices: A quantitative analysis.” Energy Econ. 28 (4): 506–522. https://doi.org/10.1016/j.eneco.2006.02.011.
Schofield, N. C. 2012. Commodity derivatives: Markets and applications. New York: Wiley.
Schweizer, M. 2002. “On Bermudan options.” In Advances in finance and stochastics, 350–357. Berlin: Springer.
Shan, L., M. J. Garvin, and R. Kumar. 2010. “Collar options to manage revenue risks in real toll public-private partnership transportation projects.” Constr. Manage. Econ. 28 (10): 1057–1069. https://doi.org/10.1080/01446193.2010.506645.
Subprasom, K., and A. Chen. 2007. “Effects of regulation on highway pricing and capacity choice of a build-operate-transfer scheme.” J. Constr. Eng. Manage. 133 (1): 64–71. https://doi.org/10.1061/(ASCE)0733-9364(2007)133:1(64).
Sultana, M., A. Rahman, and S. Chowdhury. 2013. “A review of performance based maintenance of road infrastructure by contracting.” Int. J. Productivity Perform. Manage. 62 (3): 276–292. https://doi.org/10.1108/17410401311309186.
TD Ameritrade. 2018. “Brokerage firm.” Accessed October 10, 2018. https://www.tdameritrade.com/pricing/brokerage-fees.page.
Vecer, J. 2001. “A new PDE approach for pricing arithmetic average Asian options.” J. Comput. Finance 4 (4): 105–113. https://doi.org/10.21314/JCF.2001.064.
Wang, Y., and M. Liu. 2012. “Prices of highway resurfacing projects in economic downturn: Lessons learned and strategies forward.” J. Manage. Eng. 28 (4): 391–397. https://doi.org/10.1061/(ASCE)ME.1943-5479.0000094.
Wibowo, A., and B. Kochendoerfer. 2011. “Selecting BOT/PPP infrastructure projects for government guarantee portfolio under conditions of budget and risk in the Indonesian context.” J. Constr. Eng. Manage. 137 (7): 512–522. https://doi.org/10.1061/(ASCE)CO.1943-7862.0000312.
Wibowo, A., A. Permana, B. Kochendörfer, R. T. L. Kiong, D. Jacob, and D. Neunzehn. 2012. “Modeling contingent liabilities arising from government guarantees in Indonesian BOT/PPP toll roads.” J. Constr. Eng. Manage. 38 (12): 1403–1410. https://doi.org/10.1061/(ASCE)CO.1943-7862.0000555.
Wilmot, C. G., and G. Cheng. 2003. “Estimating future highway construction costs.” J. Constr. Eng. Manage. 129 (3): 272–279. https://doi.org/10.1061/(ASCE)0733-9364(2003)129:3(272).
Zhang, X., H. Bao, H. Wang, and M. Skitmore. 2016. “A model for determining the optimal project life span and concession period of BOT projects.” Int. J. Project Manage. 34 (3): 523–532. https://doi.org/10.1016/j.ijproman.2016.01.005.
Zhao, J., and H. Y. Wong. 2012. “A closed-form solution to American options under general diffusion processes.” Quant. Finance 12 (5): 725–737. https://doi.org/10.1080/14697680903193405.
Zhou, X., and I. Damnjanovic. 2011. “Optimal hedging of commodity price risks in highway contracts.” Transp. Res. Rec. 2228: 19–25. https://doi.org/10.3141/2228-03.
Information & Authors
Information
Published In
Journal of Construction Engineering and Management
Volume 145 • Issue 5 • May 2019
Copyright
©2019 American Society of Civil Engineers.
History
Received: Feb 14, 2018
Accepted: Oct 1, 2018
Published online: Feb 20, 2019
Published in print: May 1, 2019
Discussion open until: Jul 20, 2019
Authors
Metrics & Citations
Metrics
Citations
Download citation
If you have the appropriate software installed, you can download article citation data to the citation manager of your choice. Simply select your manager software from the list below and click Download.