Options on temporary water allocation rights and their pricing

Abstract

This paper presents a methodology for defining the spot price of temporary water allocation rights for trading zones within the water market in the southern Murray–Darling Basin situated in Australia. The historical spot price is then used to calibrate a stochastic process depicting the dynamics of the water price, allowing the computation of prices of options on the underlying water price with the aim of producing reference prices to catalyse an options trading market. The most suitable stochastic model representing the water price dynamics is selected through comparing the option prices generated from four different models. Using the selected stochastic model, the most liquid trading zone in the Murray–Darling Basin water market (Zone 7) is used to demonstrate how the methodologies developed in the paper are used to calibrate the log-mean stochastic model representing the stochastic spot price dynamics and compute prices for call and put options on the underlying water spot prices. Sensitivities of the water options prices to market input data can be calculated from the formulae provided in the paper. The results presented in this work can serve as a reference tool by industry practitioners and the farming community in using options for effective risk management of water resources.