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Valuing Multiple-Exercise Option Contracts: Methodology And Application To Water Markets

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  • Villinski, Michele T.

Abstract

Option contracts for water are emerging in some U.S. states as institutional and legal modifications allow water users to devise new mechanisms to increase reliability of water supply in dry years. Option contracts for water, though, are structurally distinct from financial derivatives and often entail a lengthy lifespan and the opportunity for multiple exercise. In this paper I present the framework and results of a finite-horizon, discrete-time, stochastic dynamic programming methodology for valuing multiple-exercise option contracts. I use data from short-term water markets in the Texas Lower Rio Grande to estimate parameters for two different price processes: mean reversion and geometric Brownian motion. Key findings of the analysis include non-zero contract values for both price processes and higher contract values under geometric Brownian motion than under mean reversion.

Suggested Citation

  • Villinski, Michele T., 2004. "Valuing Multiple-Exercise Option Contracts: Methodology And Application To Water Markets," 2004 Annual meeting, August 1-4, Denver, CO 19960, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    • Handle: RePEc:ags:aaea04:19960
    DOI: 10.22004/ag.econ.19960
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    Cited by:

    1. Fleming, Euan & Villano, Renato & Williamson, Brendon, 2013. "Structuring Exotic Options Contracts on Water to Improve the Efficiency of Resource Allocation in the Australian Water Market," Papers 234295, University of Melbourne, Melbourne School of Land and Environment.
    2. Williamson, Brendon & Villano, Renato A. & Fleming, Euan M., 2008. "Structuring Exotic Options Contracts on Water to Improve the Efficiency of Resource Allocation in the Water Spot Market," 2008 Conference (52nd), February 5-8, 2008, Canberra, Australia 5992, Australian Agricultural and Resource Economics Society.

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    Keywords

    Resource /Energy Economics and Policy;

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