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A Methodology For Valuing Multiple-Exercise Option Contracts For Water

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  • Villinski, Michele T.

Abstract

In this paper I use financial derivative pricing theory as a foundation for a computational approach to valuing multiple-exercise option contracts in a natural resources setting. Evidence from the western United States shows that option contracts for water can be even more exotic than many exotic options considered in finance. For instance, one contract negotiated between a municipal water authority and a large agricultural operation allows the municipality to exercise a call option on water up to seven times in a fifteen-year period. This is a highly non-standard option; there is no simple pricing formula to calculate its value. Building on the Black-Scholes option-pricing framework I use dynamic programming techniques to construct a method for valuing such multiple-use option contracts for water.

Suggested Citation

  • 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.
    • Handle: RePEc:ags:umciwp:14379
    DOI: 10.22004/ag.econ.14379
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    References listed on IDEAS

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    1. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    2. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    3. Merton, Robert C, 1998. "Applications of Option-Pricing Theory: Twenty-Five Years Later," American Economic Review, American Economic Association, vol. 88(3), pages 323-349, June.
    4. Ari M. Michelsen & Robert A. Young, 1993. "Optioning Agricultural Water Rights for Urban Water Supplies During Drought," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 75(4), pages 1010-1020.
    5. Leland, Hayne E, 1985. "Option Pricing and Replication with Transactions Costs," Journal of Finance, American Finance Association, vol. 40(5), pages 1283-1301, December.
    6. Bonnie G. Colby, 1990. "Transactions Costs and Efficiency in Western Water Allocation," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 72(5), pages 1184-1192.
    7. 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.
    8. 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 637-654, May-June.
    9. Boyle, Phelim P & Vorst, Ton, 1992. "Option Replication in Discrete Time with Transaction Costs," Journal of Finance, American Finance Association, vol. 47(1), pages 271-293, March.
    10. Joel R. Hamilton & Norman K. Whittlesey & Philip Halverson, 1989. "Interruptible Water Markets in the Pacific Northwest," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 71(1), pages 63-75.
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    Cited by:

    1. Williamson, Brendon & Villano, Renato A. & Fleming, Euan M., 2008. "Structuring Exotic Options Contracts on Water to Improve the Efficiency of Resource Allocation in the Water Spot Market," 2008 Conference (52nd), February 5-8, 2008, Canberra, Australia 5992, Australian Agricultural and Resource Economics Society.
    2. 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.

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