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2003•RePEc: Research Papers in EconomicsOpen access

A METHODOLOGY FOR VALUING MULTIPLE-EXERCISE OPTION CONTRACTS FOR WATER

Michele T. Villinski, Villinski, Michele T.

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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.

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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.

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Available 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.

Key concepts: Exotic option, Valuation of options, Asian option, Black–Scholes model, Call option, Option value, Actuarial science, Construct (python library)

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