Applicability of Financial Derivatives for Hedging Material Price Risk in Highway Construction

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.

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