Abstract
Abstract In many situations it is natural to adopt the spot price of a traded asset (often a commodity) as the state variable. For example, in the resource extraction problem of Section 8.3 the state variable was the price of copper, while in the machinery- replacement problem of Section 10.3 it was the price of fuel. Ready availability of spot price data also makes the spot price an attractive candidate for the state variable since such data can be used to estimate the parameters needed to build the tree (the size of up and down moves and the probabilities that they occur). Moreover, because the observed price of the traded asset reflects the market’s attitude towards the risk of holding that asset in a portfolio, price data can also be used to estimate the risk-neutral probabilities.
Published Version
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