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

Shan Chen, Margaret Insley and Tony Wirjanto (twirjant@uwaterloo.ca)

No 1101, Working Papers from University of Waterloo, Department of Economics

Abstract: 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.

Pages: 60 pages
Date: 2011-01, Revised 2011-01
New Economics Papers: this item is included in nep-agr
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