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Regime Switching in Stochastic Models of Commodity Prices: An Application to an Optimal Tree Harvesting Problem

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  • Shan chen

    (Department of Economics, University of Waterloo)

  • Margaret Insley

    (Department of Economics, University of Waterloo)

Abstract

This paper investigates whether a regime switching model of stochastic lumber prices is better for the analysis of optimal harvesting problems in forestry than a more traditional single regime model. Prices of lumber derivatives are used to calibrate a regime switching model, with each of two regimes characterized by a different mean reverting process. A single regime, mean reverting process is also calibrated. The value of a representative stand of trees and optimal harvesting prices are determined by specifying a Hamilton-Jacobi-Bellman Variational Inequality, which is solved for both pricing models using a fully implicit finite difference approach. The regime switching model is found to more closely match the behaviour of futures prices than the single regime model. In addition, analysis of a tree harvesting problem indicates significant differences in terms of land value and optimal harvest thresholds between the regime switching and single regime models.

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Bibliographic Info

Paper provided by University of Waterloo, Department of Economics in its series Working Papers with number 1016.

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Length: 52 pages
Date of creation: Jul 2010
Date of revision: Jul 2010
Handle: RePEc:wat:wpaper:1016

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  1. Luis H. R. Alvarez & Erkki Koskela, 2001. "Wicksellian Theory of Forest Rotation under Interest Rate Variability," CESifo Working Paper Series 606, CESifo Group Munich.
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Cited by:
  1. Margaret Insley, 2013. "On the timing of non-renewable resource extraction with regime switching prices: an optimal stochastic control approach," Working Papers 1302, University of Waterloo, Department of Economics, revised Aug 2013.
  2. Martzoukos, Spiros H. & Zacharias, Eleftherios, 2013. "Real option games with R&D and learning spillovers," Omega, Elsevier, vol. 41(2), pages 236-249.

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