Cost-Escalation and Exchange-Rate Volatility Modelling

This chapter is aimed at handling two special types of project risks: cost escalation and exchange-rate volatility. Normally, these two risks require estimation of separate cost contingency funds. Three major modelling approaches are told apart for the evaluation of cost escalation contingency: general inflation (GI), project cost structure (PCS) and project cash flow (PCF) modelling. (The exchange-rate volatility estimate, despite being a separate activity, falls well into one of these three categories.) The GI modelling is least informative because it is based on consumer price indices (CPI). The PCS modelling is an advanced version of the GI modelling when instead of consumer baskets evaluated are baskets of major materials, equipment and services consumed by projects. Neither of them takes actual purchasing time into account. The most sophisticated and informative PCF method based on project cash flows is in the spotlight of this chapter. Producer price indices (PPI) and second transaction markups are primary parameters incorporated into project cash flows to estimate cost escalation contingencies. Nature and sources of these parameters for particular used materials, equipment and services are discussed. Similar parameters related to exchange-rate volatility modelling are also overviewed. A simplistic cost-escalation modelling case is reviewed to actualize the PCF modelling including its probabilistic version.