VALUING MULTIPLE-EXERCISE OPTION CONTRACTS: METHODOLOGY AND APPLICATION TO WATER MARKETS
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Option contracts for water are emerging in some U.S. states as institutional and legal modifications allow water users to devise new mechanisms to increase reliability of water supply in dry years. Option contracts for water, though, are structurally distinct from financial derivatives and often entail a lengthy lifespan and the opportunity for multiple exercise. In this paper I present the framework and results of a finite-horizon, discrete-time, stochastic dynamic programming methodology for valuing multiple-exercise option contracts. I use data from short-term water markets in the Texas Lower Rio Grande to estimate parameters for two different price processes: mean reversion and geometric Brownian motion. Key findings of the analysis include non-zero contract values for both price processes and higher contract values under geometric Brownian motion than under mean reversion.