What is the relevance of option pricing for forest valuation in New Zealand?

Three different option value approaches are used to estimate the value of a typical New Zealand plantation stand, under the assumption that log prices follow a random walk. Crop values are compared with the Faustmann value, the benchmark for forest valuation in New Zealand. The increase in forest value can be substantial when log prices are low and close to the exercise cost. Gains quickly diminish and become small, both as an absolute difference and as a percentage of forest value, as price increases. However, results are very sensitive to the log price model adopted. Assuming log prices are mean reverting gives higher values than Faustmann for all log prices. Stochastic Dynamic Programming (SDP) and Binomial Option Pricing (BOP) give very similar results. They evaluate the same harvest/defer harvest/never harvest options. A new Abandonment Adjusted Price approach gives results that have a similar pattern but are consistently lower than SDP and BOP. This approach only considers whether to harvest or not in the optimal year and does not allow the option of deferring harvest. At the present time, option valuation approaches have limited relevance for the practice of forest valuation in New Zealand. Practical issues (determination of the log price model, estimation of volatility, allowing for multiple log grades and modelling at the estate-level) need to be addressed before option value approaches can be routinely used for forest valuation.Forest valuation Option value Stochastic prices Rotation age