Incorporating Fire Risk into Optimal Decisions in Forestry Using a No-Arbitrage Approach
Hedges and Trees: Incorporating Fire Risk into Optimal Decisions in ... Margaret Insley and Manle Lei,Journal of Agricultural and Resource Economics; Dec 2007; 32, 3;pg 492514.
Posted: 21 Jun 2018
Date Written: December 26, 2007
This paper investigates the impact of including the risk of fire in an optimal tree harvesting model at the stand level, assuming timber prices follow a mean-reverting stochastic process. The relevant partial differential equation is derived under different assumptions about hedging the risk of fire. The assumption that fire risk is fully diversifiable is contrasted with the assumption that it can be hedged with another asset. It is conjectured that the risk-neutral probability of fire exceeds the historical probability of fire, which will affect forest land valuation. An empirical example is presented for two different silvicultural regimes.
Keywords: fire risk; forest value, hedging, jumps, no arbitrage, optimal harvesting, Poisson process, real options
JEL Classification: Q23
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