Mechanisms for transfer of price risk of construction materials

Depending on the contractual arrangement, fluctuations in materials prices expose different parties involved in a construction contract to various degrees of risk. In general, owners and/or contractors face the risk of losses when the prices of materials move upwards. Suppliers, on the other hand, face the risk of losses when the prices of materials move downwards. This study addresses this risk, taking all parties into consideration. It presents a mechanism for transferring this risk through the use of futures markets. By trading futures on construction materials; owners, contractors and suppliers may be better off when hedged against price fluctuations. They may also benefit from the positive aspects of futures trading, since this should provide a more competitive construction materials industry, and an efficient medium of disseminating valuable price information in a timely manner and at a relatively cheap cost. In order to implement the strategy of hedging the materials price risk through the use of futures contracts, construction materials must exhibit certain qualities in order to qualify for successful futures trading. A survey of these factors is presented. This is followed by an analysis of the steel industry as the viability of steel as a candidate for futures trading is investigated. Different aspects of the steel industry were considered, including: supply and demand, pricing, industry structure, steel products standardization and market sizes. The investigation demonstrated that steel conforms with the characteristics deemed necessary for futures trading and, therefore, may be considered a successful candidate. Possibilities of other construction materials as candidates for futures trading are also investigated. The preliminary analysis demonstrates that cement is also a viable candidate, since it meets the qualities regarded as necessary for successful futures trading. Further investigation is, however, required to confirm the preliminary results. The gypsum industry is quite concentrated and the size of the brick market is relatively small, therefore, the success of both gypsum board and brick as stand-alone commodities in futures trading is questionable. However, since both materials are energy intensive, and are therefore affected by the fluctuations in energy prices, the use of an energy futures contract as an alternative hedge for both materials is suggested. The use of sophisticated financial instruments such as futures, options and options on the futures to hedge financial risks may be very beneficial to the construction industry. In order for this industry to be competitive, both nationally and internationally, further research is recommended to explore possibilities for the use of modern financial instruments to hedge construction risk in a manner that will reduce overall costs to the parties involved.