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AN ARBITRAGE-FREE APPROACH TO QUASI-OPTION VALUE; Proceedings of the Fifth Joint Conference on Agriculture, Food, and the Environment, June 17-18, 1996, Padova, Italy

  • Coggins, Jay S.
  • Ramezani, Cyrus A.

In the presence of uncertainty and irreversibility, dynamic decision problems should not be solved using expected net present value analysis. The right to delay a decision can be valuable. We show that the value of this right equals Arrow and Fisher’s (1974) quasi-option value. In a discrete model we show how to derive quasi-option value using methods from finance, methods that remove altogether the need to take expected values of future stochastic variables. Two main findings are presented. First, if the stochastic dynamic process underlying the problem is known, the Arrow and Fisher and Henry (1974) result that improper use of net present value leads to too much early development, is correct. Second, if the process is not known perfectly, their result can be incorrect in the sense that net present value methods lead to the correct outcome while the dynamic rule does not.

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File URL: http://purl.umn.edu/14469
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Paper provided by University of Minnesota, Center for International Food and Agricultural Policy in its series Working Papers with number 14469.

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Date of creation: 1996
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Handle: RePEc:ags:umciwp:14469
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  1. Graham, Daniel A, 1981. "Cost-Benefit Analysis under Uncertainty," American Economic Review, American Economic Association, vol. 71(4), pages 715-25, September.
  2. Richard C. Bishop, 1982. "Option Value: An Exposition and Extension," Land Economics, University of Wisconsin Press, vol. 58(1), pages 1-15.
  3. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
  4. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  5. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  6. Arrow, Kenneth J & Fisher, Anthony C, 1974. "Environmental Preservation, Uncertainty, and Irreversibility," The Quarterly Journal of Economics, MIT Press, vol. 88(2), pages 312-19, May.
  7. Majd, Saman & Pindyck, Robert S., 1987. "Time to build, option value, and investment decisions," Journal of Financial Economics, Elsevier, vol. 18(1), pages 7-27, March.
  8. Dennis C. Cory & Bonnie Colby Saliba, 1987. "Requiem for Option Value," Land Economics, University of Wisconsin Press, vol. 63(1), pages 1-10.
  9. Conrad, Jon M., 1995. "On the Option Value of Old-Growth Timber: The Case of the Headwaters Forest," Working Papers 127956, Cornell University, Department of Applied Economics and Management.
  10. Arrow, Kenneth J & Kurz, Mordecai, 1970. "Optimal Growth with Irreversible Investment in a Ramsey Model," Econometrica, Econometric Society, vol. 38(2), pages 331-44, March.
  11. Hanemann, W. Michael, 1989. "Information and the concept of option value," Journal of Environmental Economics and Management, Elsevier, vol. 16(1), pages 23-37, January.
  12. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
  13. Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 479-508, August.
  14. Schmalensee, Richard, 1972. "Option Demand and Consumer's Surplus: Valuing Price Changes under Uncertainty," American Economic Review, American Economic Association, vol. 62(5), pages 813-24, December.
  15. Reed, William J., 1993. "The decision to conserve or harvest old-growth forest," Ecological Economics, Elsevier, vol. 8(1), pages 45-69, August.
  16. Bohm, Peter, 1975. "Option Demand and Consumer's Surplus: Comment," American Economic Review, American Economic Association, vol. 65(4), pages 733-36, September.
  17. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  18. Henry, Claude, 1974. "Investment Decisions Under Uncertainty: The "Irreversibility Effect."," American Economic Review, American Economic Association, vol. 64(6), pages 1006-12, December.
  19. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
  20. Fisher, Anthony C. & Hanemann, W. Michael, 1987. "Quasi-option value: Some misconceptions dispelled," Journal of Environmental Economics and Management, Elsevier, vol. 14(2), pages 183-190, June.
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