Valuing a price cap contract for material procurement as a real option

This paper uses real option methodology to compare the cost of a long‐term contract with a price cap to that of spot purchases in construction material procurement. In construction, material procurements are usually short‐term, project‐based and subject to high price volatility. These characteristics and the competitive nature of the industry lower the profit margin of contractors. We have observed that contractors purchase a stable amount of commodity materials such as concrete, structural steel and lumber year after year. For contractors, the price cap reduces the price volatility of materials without their being obliged to purchase a certain quantity; for suppliers, the price‐cap contracts give them steady demand and a bigger market share. We evaluate this price‐cap contract as a real option and find the contractor's optimal ordering policy. When materials are not frequently traded, we model price processes by using related market information and then evaluate the idiosyncratic uncertainties in a risk‐neutral setting. Our methodology does not require market completeness and incorporates some of the results of the latest research in finance such as correlation pricing, option pricing and zero level pricing, as well as Monte Carlo simulation.