Managing construction risk with weather derivatives

Abstract

Abstract Among construction industry participants, weather has been perceived to be one of the most critical factors impacting project cash-flows. The overall impact of weather on the contractor’s project objectives is non-trivial due to construction industry incentive structures and contract specifics. This paper presents a framework that leverages stylized facts from the construction industry to motivate the use of weather derivatives in managing the non-trivial weather impacts. The proposed framework is demonstrated using data provided by a large construction contractor. We show that weather derivative portfolios used for hedging purposes by the contractor can address the contractor’s aversion for losses as well as the complicated relationship between weather and construction. Furthermore, weather derivative hedging reduces the contractor’s incentive to partake in risk chasing behavior in the face of weather delays and reduces the likelihood of the contractor exploiting other claims channels within the project contract.