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Structuring Exotic Options Contracts on Water to Improve the Efficiency of Resource Allocation in the Water Spot Market

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  • Williamson, Brendon
  • Villano, Renato A.
  • Fleming, Euan M.

Abstract

With the current drought in South-Eastern Australia highlighting the scarcity and value of inland Australia’s water resources, focus turns to how these resources can be allocated more efficiently. The first major step was taken almost a decade ago with the separation of land and water property rights allowing openly traded water markets. This study assesses the potential economic benefits that options contracts bring to the water market in the Murray Valley water market. Exotic call options are estimated using both Black-Scholes and skewness-and-kurtosis-amended Black-Scholes financial option pricing methods that are based on three years of data on water prices. While the presence of options would result in significant economic benefits in the more efficient trade of water on the open market for lower-value crops, there were mixed results from the attempt to price such options.

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Bibliographic Info

Paper provided by Australian Agricultural and Resource Economics Society in its series 2008 Conference (52nd), February 5-8, 2008, Canberra, Australia with number 5992.

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Date of creation: 2008
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Handle: RePEc:ags:aare08:5992

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Postal: AARES Central Office Manager, Crawford School of Public Policy, ANU, Canberra ACT 0200
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Related research

Keywords: options; skewness-and-kurtosis-amended Black-Scholes model; water; Environmental Economics and Policy; Financial Economics; Research Methods/ Statistical Methods; Resource /Energy Economics and Policy;

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  1. Hertzler, Greg, 2004. "Weather Derivatives and Yield Index Insurance As Exotic Options," 2004 Conference (48th), February 11-13, 2004, Melbourne, Australia 58705, Australian Agricultural and Resource Economics Society.
  2. 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).
  3. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  4. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  5. Randall, Alan, 1981. "Property Entitlements And Pricing Policies For A Maturing Water Economy," Australian Journal of Agricultural Economics, Australian Agricultural and Resource Economics Society, vol. 25(03), December.
  6. Jondeau, Eric & Rockinger, Michael, 2000. "Reading the smile: the message conveyed by methods which infer risk neutral densities," Journal of International Money and Finance, Elsevier, vol. 19(6), pages 885-915, December.
  7. Hansen, Kristiana & Howitt, Richard E. & Williams, Jeffrey C., 2006. "Implementing Options Markets in California To Manage Water Supply Uncertainty," 2006 Annual meeting, July 23-26, Long Beach, CA 21218, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
  8. Villinski, Michele T., 2003. "A Methodology For Valuing Multiple-Exercise Option Contracts For Water," Working Papers 14379, University of Minnesota, Center for International Food and Agricultural Policy.
  9. Chauveau, Thierry & Gatfaoui, Hayette, 2002. "Systematic risk and idiosyncratic risk: a useful distinction for valuing European options," Journal of Multinational Financial Management, Elsevier, vol. 12(4-5), pages 305-321.
  10. Howitt, Richard E., 1994. "Empirical analysis of water market institutions: The 1991 California water market," Resource and Energy Economics, Elsevier, vol. 16(4), pages 357-371, November.
  11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  12. Heston, Steven L, 1993. " Invisible Parameters in Option Prices," Journal of Finance, American Finance Association, vol. 48(3), pages 933-47, July.
  13. Corrado, Charles J & Su, Tie, 1996. "Skewness and Kurtosis in S&P 500 Index Returns Implied by Option Prices," Journal of Financial Research, Southern Finance Association & Southwestern Finance Association, vol. 19(2), pages 175-92, Summer.
  14. Jarrow, Robert & Rudd, Andrew, 1982. "Approximate option valuation for arbitrary stochastic processes," Journal of Financial Economics, Elsevier, vol. 10(3), pages 347-369, November.
  15. Christine A. Brown & David M. Robinson, 2002. "Skewness and Kurtosis Implied by Option Prices: A Correction," Journal of Financial Research, Southern Finance Association & Southwestern Finance Association, vol. 25(2), pages 279-282.
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