Guidelines and consideration for construction contractors using commodity futures as hedging tools for mitigating construction material pricing risk

Abstract

Many would argue that risk management is the single most important element of a construction contractor's business enterprise. A significant risk to a contractor’s profitability is increased costs of construction materials. In many cases construction materials are the largest single component of a construction project budget. Contractors generally utilize contingency funds or contractual price adjustments clauses to address the risk associated with changes in construction material pricing. However, the use of contingency and contractual mechanisms comes at a cost. The additional costs are especially detrimental in construction markets that are competitively bid, because higher bid prices result in winning fewer jobs. An alternative risk mitigation is the use of commodity futures to hedge the risk of increasing construction material prices. A hedge is strategy for limiting losses by holding a portfolio of noncorrelated assets. The research of this study evaluates the application of commodity futures for hedging material pricing risk in the construction industry. Through statistical analysis and simulation studies this research concludes that utilizing commodity futures as a hedging strategy is effective risk mitigation against increased construction material costs. In addition, through a literature review this study explains the fundamentals of the commodity future market, and presents the mechanics of trading commodity futures. A guideline for using commodity futures as a hedging tool is included in this study.