Collar Option Model for Managing the Cost Overrun Caused by Change Orders

Sanghyo Lee and Kyunghwan Kim
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Sanghyo Lee: Institute of Occupational Medicine, Social Medicine and Environmental Medicine, Goethe-University, Theodor-Stern-Kai 7, Haus 9b, Frankfurt am Main 60590, Germany
Kyunghwan Kim: Department of Architectural Engineering, Konkuk University, 120 Neungdong-ro, Gwangjin-gu, Seoul 143-701, Korea

Sustainability, 2015, vol. 7, issue 8, 1-15

Abstract: Effective change order management is very important in maintaining the financial sustainability of various stakeholders related to construction projects by minimizing cost overruns. In this study, we propose a zero-cost risk management approach based on the collar option model in order to control for the loss caused by change orders, the main cause of cost overruns in construction projects. We apply this model to actual projects for empirical analysis. The analysis, based on 237 projects, indicates that insurance buyers benefit from the collar option model in 46% of the cases, while insurance sellers do so in 53% of the cases. In most cases, the insurance buyer is the owner. According to the model, the owner experiences a loss when the cost overrun caused by change orders is lower than what was expected. In such cases, it is appropriate to conclude that the loss is not caused by the collar option model, but by the absence of additional revenue. However, the insurance seller suffers a loss if the cost overrun is higher than the strike price of the call option. Thus, the insurance seller needs to have expertise in construction management.

Keywords: insurance; change orders; cost overrun; collar option model; option theory; financial sustainability (search for similar items in EconPapers)
JEL-codes: O13 Q Q0 Q2 Q3 Q5 Q56 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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