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A Two Factor Model for Water Prices and Its Implications for Evaluating Real Options and Other Water Price Derivatives
Authors:Chi H Truong
Institution:1. +612‐9850‐8481+612‐9850‐8586;2. Department of Applied Finance and Actuarial Studies, Faculty of Business and Economics, Macquarie University, , North Ryde, NSW, 2109 Australia
Abstract:Single stochastic water price processes may not be able to capture relevant impacts of temporary shocks and permanent shocks on water prices. In this paper, a two factor modeling framework is proposed to incorporate the impacts of these shocks. The model is used to analyze the optimal investment rule when such a composite water price process applies. It is found that ignoring the information on long‐run water price, as in one factor models, can cause an exercise of the real option too early, and result in even negative investment net present value when long‐run water price is low. Giving rise to closed form solutions of European option values, the modeling framework also contributes to facilitate the imminent emergence of water price derivatives in water markets.
Keywords:
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