Active timber management by outsourcing stumpage price uncertainty with the American put option

Abstract

Timber production is risky, with price uncertainties caused by stumpage price fluctuations. In this study, the American put option is employed to outsource such uncertainty and establish the reservation prices at various stand ages. Put option values and the reservation prices derived thereof, thus, help forestland owners decide whether the stumpage price is high enough to justify an immediate timber harvest. With a series of simulations, we demonstrated that using an American put option to cover the downside price risk could substantially increase the average land expectation value compared to the certainty case. Besides, the simulations confirm that buying an American option as a price insurance would deduct land expectation values compared to the methods proposed by Brazee and Mendelsohn. In addition, we proposed a rolling put option method that allows forestland owners to buy partial length put options to balance their cost and price uncertainty protection. Overall, with the help of American put option, forestland owners for the first time could actively make their harvest decisions from the price setter perspective instead of being pure market price taker like they have been since the beginning of commercial forestry.