Managing Construction Costs
Construction projects can face various elements of risk with problems arising when exogenous shocks bring volatility to material pricing. As projects are rarely an overnight endeavor, unmanaged cost structuring may have detrimental impacts on a project as unforeseen price fluctuations in materials can greatly impact the profitability of a task. As the construction environment experiences fierce competition and low margins, cost risk awareness has become increasingly important to maintain profitability.
A common use of hedging is the effective implementation of a price ceiling. Generally, this occurs when a company currently has a position or anticipates establishing a position in the physical market.
For example, a Housing Renovation Company requires 110,000 MBF (thousand board feet) of lumber to complete a housing project. The company fears that the physical price of lumber may rise and does not want to incur the extra cost of rising inputs. To establish the maximum price they will pay for 110,000 MBF, they can take a long futures position prior to purchasing their physical lumber. A lumber contract conveniently is specified at 110,000 MBF with a tick size of $110. With July Lumber Futures trading at 1190, if the price of lumber futures rise to 1200, a long position will earn a profit of $1100 ($110x10=$1100). As the price increases, the company may face a higher purchasing price, but their long futures position offsets the now higher cost of purchasing physical lumber. Conversely, if the price of lumber futures fell to 1180, a $1100 loss would be incurred but would be offset by the company now purchasing lumber for a cheaper price to complete their project.
With hedging, the company should not expect to generate profits but instead should seek to minimize a rise in expenditure should there be an adverse price fluctuation and provide a less volatile cost base for their project.