Planting Real Option in Cash Rent Valuation, The

Xiaodong Du, David A. Hennessy
February 2008  [08-WP 463]

After entering into farmland rental contracts in the fall, a tenant farmer has the planting flexibility to choose between corn and soybeans. Failure to account for this switching option will bias estimates of what farmers should pay to rent land. Applying contingent claims analysis methods, this study explicitly derives the real option value function. Comparative statics with respect to the volatilities of underlying state variables and their correlations are derived and discussed. Dynamic hedging deltas in this real option context are also developed. Monte Carlo simulation results show that the average cash rent valuation for the real option approach is 11% higher than that for the conventional net present value (NPV) method. The simulated dynamic hedging deltas are shown to differ from the ones implied by the NPV method.

Keywords: cash rent, delta hedging, Monte Carlo simulation, multivariate GARCH, real option, Ricardian rent.

JEL classification: C5, G1, Q1.

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