Journal of Forest Economics > Vol 16 > Issue 2

Contrasting two approaches in real options valuation: Contingent claims versus dynamic programming

M.C. Insley, , minsley@uwaterloo.ca T.S. Wirjanto, ,
 
Suggested Citation
M.C. Insley and T.S. Wirjanto (2010), "Contrasting two approaches in real options valuation: Contingent claims versus dynamic programming", Journal of Forest Economics: Vol. 16: No. 2, pp 157-176. http://dx.doi.org/10.1016/j.jfe.2009.11.002

Published: 0/4/2010
© 0 2010 M.C. Insley, T.S. Wirjanto
 
Subjects
 
Keywords
JEL Codes:Q23D81G11
Optimal tree harvestingReal optionsContingent claimsDynamic programming
 

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In this article:
Introduction
CC and DP approaches to a real options problem
Empirical example: comparing CC and DP in an optimal harvesting problem
Empirical results
Summary and concluding remarks

Abstract

This paper compares two well-known approaches for valuing a risky investment using real options theory: contingent claims (CC) with risk neutral valuation and dynamic programming (DP) using a constant risk adjusted discount rate. Both approaches have been used in valuing forest assets. A proof is presented which shows that, except under certain restrictive assumptions, DP using a constant discount rate and CC will not yield the same answers for investment value. A few special cases are considered for which CC and DP with a constant discount rate are consistent with each other. An optimal tree harvesting example is presented to illustrate that the values obtained using the two approaches can differ when we depart from these special cases to a more realistic scenario. We conclude that for real options problems the CC approach is preferred when data exists (such as futures prices) that allow the estimation of the market price of risk or convenience yield. Even when such data do not exist we argue that the CC approach is preferred as it has the advantage of allowing the individual specification of the prices of different sources of risk.

DOI:10.1016/j.jfe.2009.11.002