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The Impact of Stochastic Convenience Yield on Long-term Forestry Investment Decisions

Listed author(s):
  • Shan Chen
  • Margaret Insley

    (Department of Economics, University of Waterloo)

  • Tony Wirjanto

    (School of Accounting & Finance and the Department of Statistics & Actuarial Science, University of Waterloo)

This paper investigates whether convenience yield is an important factor in determining optimal decisions for a forestry investment. The Kalman filter method is used to estimate three different models of lumber prices: a mean reverting model, a simple geometric Brownian motion and the two-factor price model due to Schwartz (1997). In the latter model there are two correlated stochastic factors: spot price and convenience yield. The two-factor model is shown to provide a reasonable fit of the term structure of lumber futures prices. The impact of convenience yield on a forestry investment decision is examined using the Schwartz (1997) long-term model which transforms the two-factor price model into a single factor model with a composite price. Using the long-term model an optimal harvesting problem is analyzed, which requires the numerical solution of an impulse control problem formulated as a Hamilton-Jacobi-Bellman Variational Inequality. We compare the results for the long-term model to those from single-factor mean reverting and geometric Brownian motion models. The inclusion of convenience yield through the long-term model is found to have a significant impact on land value and optimal harvesting decisions.

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Paper provided by University of Waterloo, Department of Economics in its series Working Papers with number 1101.

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Length: 60 pages
Date of creation: Jan 2011
Date of revision: Jan 2011
Handle: RePEc:wat:wpaper:1101
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