On Forest Rotation under Interest Rate Variability

Authors: Alvarez L.H.R.¹; Koskela E.²

Source: International Tax and Public Finance, Volume 10, Number 4, August 2003 , pp. 489-503(15)

Publisher: Springer

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Abstract:

The current literature on optimal forest rotation makes the unrealistic assumption of a constant interest rate although harvesting decisions of forest stands are typically subject to relatively long time horizons. We apply the single rotation framework to extend the existing studies to cover the unexplored case of variable interest rate. We show that even in the deterministic case if the current interest rate deviates from its long-run steady state, interest rate variability may change the rotation age significantly when compared with the constant discounting case. Further, and importantly, allowing for interest rate uncertainty as a mean reverting process and forest value as a geometric Brownian motion, we can provide an explicit solution for the two dimensional path-dependent optimal stopping problem. Increased interest rate volatility is shown to lengthen the optimal rotation period. Numerical calculations show that interest rate volatility has a large quantitative importance.

Keywords: optimal rotation; variable interest rates; optimal stopping; free boundary problems

Language: English

Document Type: Research article

Affiliations: 1: Department of Economics, Quantitative Methods in Management, Turku School of Economics and Business Administration, FIN-20500 Turku, Finland luis.alvarez@tukkk.fi 2: Department of Economics, University of Helsinki, FIN-00014 Helsinki, Finland erkki.koskela@helsinki.fi

Publication date: 2003-08-01