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Abstract—This study proposes a materials procurement contracts

model to which the zero-cost collar option is applied for heading price

fluctuation risks in construction.The material contract model based on

the collar option that consists of the call option striking zone of the

construction company(the buyer) following the materials price

increase andthe put option striking zone of the material vendor(the

supplier) following a materials price decrease. This study first

determined the call option strike price Xcof the construction company

by a simple approach: it uses the predicted profit at the project starting

point and then determines the strike price of put option Xpthat has an

identical option value, which completes the zero-cost material

contract.The analysis results indicate that the cost saving of the

construction company increased as Xcdecreased. This was because the

critical level of the steel materials price increasewas set at a low level.

However, as Xcdecreased, Xpof a put option that had an identical

option value gradually increased. Cost saving increased as Xc

decreased. However, as Xpgradually increased, the risk of loss from a

construction company increased as the steel materials price decreased.

Meanwhile, cost saving did not occur for the construction company,

because of volatility. This result originated in the zero-cost features of

the two-way contract of the collar option. In the case of the regular

one-way option, the transaction cost had to be subtracted from the cost

saving. The transaction cost originated from an option value that

fluctuated with the volatility. That is, the cost saving of the one-way

option was affected by the volatility. Meanwhile, even though the

collar option with zero transaction cost cut the connection between

volatility and cost saving, there was a risk of exercising the put option.

Keywords—Construction materials, Supply chain management,

Procurement, Payment, Collar option

I. INTRODUCTION

HE construction project’s profitability is directly affected

by the accuracy of cost estimation at the planning stage[4].

Given that materials and equipmentsconstituteasignificant

proportion (i.e. 60% in 1979)[5] of the total construction

project cost [4], it depends on the contractors’ ability to take off

the quantity of resources correctly and obtain exact price of

those [17]. However, due to the materials price fluctuation, they

have experienced difficulties to do this. Moreover, the

materials demand from the construction industry occurs in a

short-termproject-based manner[23]. Compared to the other

manufacturing industries that first produces and then sells, the

construction industry is based on order-to-delivery process.

Furthermore, the moment to order and pay for materials can

H. L. YimDepartment of Sustainable Architectural Engineering, Hanyang

University, Seoul, Korea (phone: 82-2-2220-0307, fax: 82-2-2296-1583,

e-mail: o_os@nate.com).

S. H. LeeDepartment of Sustainable Architectural Engineering, Hanyang

University, Seoul, Korea.(e-mail: siegfried_sun@hotmail.com)

S. K. YooDepartment of Sustainable Architectural Engineering, Hanyang

University, Seoul, Korea.(e-mail:james_yoo@hotmail.com)

J. J. Kim, Department of Architectural Engineering, Hanyang University,

Seoul, Korea (e-mail: jjkim@hanyang.ac.kr).

vary according to delivery methods. For this reason,

construction companies may order materials after the client

approve specifications. Due to this unique context, an increase

in the construction cost due to the materials price fluctuation is

directly connected to the decrease in profits for the construction

company unless payment methods to remunerate the lost (i.e.

cost-plus-fee) are agreed in contract. However, this kind of

payment method can increase the unpredictability in terms of

budget for the client: in other words, risk is just passed to the

other side. Regarding the situation discussed so far, a method is

required that can hedge risks derived from the material price

fluctuation. In this aspect, Ng et al.[23], suggested that the

materials supplier and buyer should form a dynamic

relationship that can support strategic flexibility. According to

them, the option theory is likely to support the both sides:

buyers, contractors, can obtain flexibility to minimize

inventory cost and hedge price fluctuation; and materials

suppliers can diversify their price risks and stabilize production

schedule. However, such flexibility causes some costs to the

related parties[2]. Especially, a one-way option contract, either

from supplier to demander or from demander to supplier,

option buyer who participated passively in the contract should

pay additional option transaction cost entailed by an uncertain

future.Unlike financial organizations, construction company

andmaterials suppliers are not specializing in risky

investment.In order to provide practical method to hedge risks,

alternative options without additional costs need to be

presented. This study proposes a materials procurement

contracts model to which the zero-cost collar option [6, 16, 20]

is applied for heading price fluctuation risks in construction.

Given that the risk hedge can cause inequality among parties,

this issue should be approached in the boundary of supply chain

management (SCM) in which relationship between supplier

and buyer is regarded important.

II.SUPPLY CHAIN MANAGEMENT AND MATERIALS

PROCUREMENTLITERATURE

In general, suppliers experience difficulties in determining

the price andamount of products

uncertainty.There have been various studies focusing on

contract types that can secure flexibility to reduce the risk from

such uncertainty. Lian et al.[19] suggested a specific supply

contract model in which a buyer receives discounts for

committing to purchase in advance. The option theory applied

in this study was first introduced for securing flexibility in

response to the future uncertainty of financial assets. The study

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applying an option theory, arguing that the system should

secure sufficient flexibility in order to promptly respond to the

market needs. They mentioned that backup

two-period, quantity-flexibility

pay-to-delay arrangements, are special types of contracts that

use options. That is, suppliers and buyers can fo

types of contracts by appropriately making use of option

theory.Construction industry hasalso focused on the effective

management of material procurement from the viewpoint of

SCM. The research can be classified as follows:

research [28], management systems [4, 5], partnerships

material delivery [1], and supplier selection [7]

studies have examined how to bring flexibility to the material

price fluctuation in a relationship between the material supplier

and the construction company.In fact, Ng et al.

long-term contracts with price caps related to the construction

material supply by making use of real options. The material

contract suggested in this paper is similar to a financial call

option, in that the buyer exercises the option when the materials

price is higher than the strike price. This type of contract

enables the material vendor to establish an effective materials

production plan so that it can conclude a long

with the demander while increasing its share

Moreover, the construction company can have the flexibility to

limit the material price fluctuation within a certain

range.Nevertheless, in the case of those one

contracts, the option buyer, that is, the construction company,

should pay the option price to the option seller of the material

supplier. As a result, the construction company can be reluctant

in option contracts, due to the additional expenditure.

option has been mentioned as an alternative

with problems due to the additional cost (i.e.

Linden [20]).

contracts, contracts, as as well well as as

III. THEORETICALBACKGROUNDOF COLLAR

An option is a security giving the right to buy or sell an asset,

subject to certain conditions, within a specified period of

The most common types of options are a call option and a put

option. A collar option involves buying an out

call and selling an out-of-the-money put of equal value with the

same expiration date[20]. So, a collar allows the utility a high

level of sophistication by buying downside and selling upside

protection, with a designated amount within either side that

does not trigger any action for the both parities

option is often used for currency trading in financial sectors.

Linden [20] examined how to reduce risk in a foreign currency

transaction by using a zero-cost currency option collar as a

hedging tool.Moreover, Bettis et al. [6] used a collar option for

flexibly hedging the assetprice volatility risk of company

shareholders at zero-cost. There are studies that examined the

application of the collar option in hedging the realprice

volatility risk. Carter et al. [10] investigated whether the collar

option could be used for hedging fuelprice volatili

airline industry and reported that the collar option had the

advantage of zero cost, while keeping the option risk at a proper

level.It can be assumed that the price fluctuation risk can be

reduced in constructionif the collar option isthe collar option is introduced to a

applying an option theory, arguing that the system should

delay arrangements, are special types of contracts that

use options. That is, suppliers and buyers can form diverse

types of contracts by appropriately making use of option

focused on the effective

management of material procurement from the viewpoint of

The research can be classified as follows: fundamental

partnerships [18],

and supplier selection [7].However, few

studies have examined how to bring flexibility to the material

price fluctuation in a relationship between the material supplier

Ng et al. [23] analyzed

caps related to the construction

material supply by making use of real options. The material

contract suggested in this paper is similar to a financial call

e buyer exercises the option when the materials

price is higher than the strike price. This type of contract

enables the material vendor to establish an effective materials

production plan so that it can conclude a long-term contract

e increasing its shares of the market.

should pay the option price to the option seller of the material

supplier. As a result, the construction company can be reluctant

in option contracts, due to the additional expenditure. Collar

option has been mentioned as an alternative method to cope

with problems due to the additional cost (i.e. Fuller [16];

OLLAR OPTION

An option is a security giving the right to buy or sell an asset,

subject to certain conditions, within a specified period of time.

The most common types of options are a call option and a put

option. A collar option involves buying an out-of-the-money

money put of equal value with the

So, a collar allows the utility a higher

level of sophistication by buying downside and selling upside

protection, with a designated amount within either side that

the both parities [16].The collar

option is often used for currency trading in financial sectors.

examined how to reduce risk in a foreign currency

cost currency option collar as a

used a collar option for

price volatility risk of company

cost. There are studies that examined the

application of the collar option in hedging the realprice

investigated whether the collar

option could be used for hedging fuelprice volatility risk in the

and reported that the collar option had the

advantage of zero cost, while keeping the option risk at a proper

the price fluctuation risk can be

materialprocurementcontract model between construction

A.Proposed framework

The material contract model based on the collar option that

consists of the call option striking zone of the construction

company(the buyer) following the materials price increase

andthe put option striking zone of the material vendor(th

supplier) following a materials price decrease.

concept of a material procurement contract model introducing

the collar option.If the materials price at t

between the put option strike price

strike price (Xc). The magnitude of the increment of materials

price (Dc)and decrementof materials price

differaccording to the probabilities of price increases and

decreases. That is, Dc>Dp when the overall materials price

fluctuation has an upward trend, and D

fluctuation has a downward trend.In order to

zero-cost material procurementcontract model, the X

values to be determined should equate the option value with

call option and put option. Due to the uniqu

construction industry that produces on

construction company obtains profits

between the contract price and the

the contract price is fixed, the materials price fluctuation

very sensitive issue for the construction company.

study first determined the call option strike price X

construction company by a simple approach: it uses the

predicted profit at the project starting point

the strike price of put option Xpthat has an identical option

value, which completes the zero-cost material contract.

material procurement contract model suggested in this study,

is assumed that the contract is

construction company rather than at the level of a

its projects that are undergone during the option contract period

are comprehensively contained in the supply contract with the

material vendor. The construction company can limit the

increase in the materials price below a certain level, while the

material vendor can secure a stable demander with a

construction company level requirement instead of a

project-level requirement. This contributes to increasing the

materials productivity because the supplier can

effective production plan.

Fig. 1 Concept of a material procurement

the collar optionthe collar option

contract model between construction

and material vendors, since the increment of

materials price is kept below the strike price of the call

option.The material vendor can obtain a stable demander, since

term contract with the collar option until

the termination period. Moreover, it can acquire additional

since the decrement of the materials price is kept above

ROCUREMENTCONTRACTMODEL

OLLAR OPTION

The material contract model based on the collar option that

consists of the call option striking zone of the construction

company(the buyer) following the materials price increase

andthe put option striking zone of the material vendor(the

supplier) following a materials price decrease. Fig. 1 is the

procurement contract model introducing

If the materials price at t=0 is S, S is located

between the put option strike price (Xp) and the call option

he magnitude of the increment of materials

and decrementof materials price

according to the probabilities of price increases and

when the overall materials price

ard trend, and Dc

fluctuation has a downward trend.In order to complete the

(Dp) can

contract model, the Xcand Xp

values to be determined should equate the option value with the

Due to the unique characteristics of a

construction industry that produces on the order, the

profits from the difference

and the construction cost.Because

the materials price fluctuation is a

very sensitive issue for the construction company.Hence, this

determined the call option strike price Xcof the

construction company by a simple approach: it uses the

at the project starting point and then determines

that has an identical option

cost material contract. In the

contract model suggested in this study, it

the contract is made at the level of a

pany rather than at the level of a project as all

during the option contract period

are comprehensively contained in the supply contract with the

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B.Approach for Setting up the Striking Price Approach for Setting up the Striking Price

This study determines the call option strike price of a

construction company by using profit from its projects during

the option contract. As the project profitare generated

Xc? S — Pum

It is possible that the total profit will be positive, even when

CPI= BCWP/ACWPCPI= BCWP/ACWP

(4) (4) (4)

EAC. Estimate At Completion

ACWP :Actual Cost for Work Performed