Regime switching in stochastic models of commodity prices: An application to an optimal tree harvesting problem

Abstract

This paper investigates a regime switching model of stochastic lumber prices in the context of an optimal tree harvesting problem. Using lumber derivatives prices, two lumber price models are calibrated: a regime switching model and a single regime model. In the regime switching model, the lumber price can be in one of two regimes in which different mean reverting price process prevail. An optimal tree harvesting problem is specified in terms of a linear complementarity problem which is solved using a fully implicit finite difference, fully-coupled, numerical approach. The land value and critical harvesting prices are found to be significantly different depending on which price model is used. The regime switching model shows promise as a parsimonious model of timber prices that can be incorporated into forestry investment problems.