WEAI/AERE 2009 - Individual Paper Abstract
Title: The Impact of Stochastic Convenience Yield on Long-term Forestry Investment Decisions
Author(s): Shan CHEN, Department of Economics, University of Waterloo, Waterloo, Ontario, N2L 3G1, s32chen@artsmail.uwaterloo.ca; Margaret Insley, Department of Economics, University of Waterloo; Tony Wirjanto, University of Waterloo (photo: Algonquin Park forest, Shan Chen)
Abstract: This paper contributes to the literature on optimal harvesting of renewable natural resources under market uncertainty. The paper investigates the importance of modeling the stochastic convenience yield of lumber in the context of an optimal tree harvesting problem. For storable commodities and commodities that serve as inputs to other production, like copper and crude oil, convenience yield is thought to play an important role in price formation and, as well, it helps to explain the term structure of commodity futures prices. Schwartz's (1997) two-factor model has been successfully applied to model several non-renewable natural resources, including crude oil and copper. The model provides a reasonable fit of long-term futures prices which are essential for valuing long-term commodity-linked investments. The seasonal harvesting of trees, as well as the importance of wood products as inputs to other industries, suggest that convenience yield may be important to understanding the dynamics of timber prices. We examine the performance of this two-factor model in terms of its ability to characterize the price of lumber derivatives and its impact on long-term forestry investment decisions.