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

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  • Fleming, Euan
  • Villano, Renato
  • Williamson, Brendon

Abstract

The potential economic benefits that options contracts bring to the Murray Valley water market in Australia are assessed. Exotic call option prices are estimated using Black-Scholes and skewness-and-kurtosis-amended Black-Scholes option closed-form pricing methods that are based on mean weekly water prices between 2004 and 2008. While options would result in significant economic benefits through more efficient trade of water on the open market for lower-value crops, there were mixed results from attempts to price them. Results show that use of the standard Black-Scholes formula is likely to undervalue option prices considerably at all but improbably low levels of volatility in water prices. Water option prices are high relative to the net present value of option benefits for recent levels of volatility, which is likely to discourage the development of a water options market. Alternatives to reduce the option prices are discussed. Other potential constraints to the implementation of a water options trading system are outlined.

Suggested Citation

  • 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.
    • Handle: RePEc:ags:auagpe:234295
    DOI: 10.22004/ag.econ.234295
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    1. Dolores Rey & Alberto Garrido & Javier Calatrava, 2016. "Comparison of Different Water Supply Risk Management Tools for Irrigators: Option Contracts and Insurance," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 65(2), pages 415-439, October.

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