3.1 Natural Resources and Land

Question 1

What is an exchange option?

Answer 1

Option to exchange one risky asset for another rather than to buy or sell one asset at a fixed exercise or strike price.

Question 2

What does volatility of an exchange option depend on?

Answer 2

1. volatility of the price of the asset(s) being delivered
2. volatility of the price of the asset(s) being received
3. covariance or correlation coefficient between the prices.

Question 3

Discuss natural resources as an exchange option

Answer 3

If the cost of development is highly correlated with the value of the commodity, the volatility of the value of the exchange will be lower and the value of the option will be lower (everything else being equal). The option can be especially valuable when development costs and commodity prices are not highly positively correlated.

The prices of developing a resource can change due to technological advances and other factors, such as environmental and regulatory concerns.

Question 4

Discuss the concept of moneyness as it pertains to the development of natural resources

Answer 4

Moneyless depends on the spread between benefits and costs of development. Being in the money means that if the raw materials are exercised now, the sale of end product will exceed current cost of development.

Question 5

Discuss why some in-the-money development options should not be immediately exercised

Answer 5

Option theory: convex nature of payoff diagram illustrates asymmetric payoff to options where long position increased value at increasing rate in one direction and vice versa.

Question 6

Intrinsic Option Value

Answer 6

is greater of $0 and the value of an option if exercised immediately.

Question 7

Time Value of Option

Answer 7

Excess of an option’s price above its intrinsic value.

Question 8

Option Value =

Answer 8

Intrinsic Option Value + Time Value of Option

Question 9

Describe the relationship between the moneyness of natural resource options and short-term financial risks

Question 10

What are real assets?

Answer 10

Economic resources that create consumption opportunities available to people. All consumption ultimately originates from real assets.

Financial assets are the counterpart to real assets. Financial assets serve as conduits of value rather than as direct creators of consumption opportunities.

Question 11

What are Natural Resources

Answer 11

Real assets that have received no or almost no human alteration.

Question 12

Difference between natural resources and commodities:

Answer 12

Natural resources are unaltered. E.g. Undeveloped land and timberland are natural resources while timber is commodity.

Examples of natural resources include oil, natural gas, coal, ore, land, water, wind

Question 13

How are natural resources owned?

Answer 13

Institutional ownership of natural resources can be achieved through land ownership that includes underground rights, ownership of mineral rights, or leasing of mineral rights.

There are some opportunities for pure plays on natural resources through private partnerships or listed partnerships (MLPs).

However, most global natural resources are either owned by governments or leased to operating firms.

Question 14

Timberland Investment Management Organization (TIMO)

Answer 14

A TIMO brokers and manages timberland real estate investments for institutional investors. TIMOs advise on and manage the investments in return for a management fee and a share of the profits from the harvest.

Question 15

Define cap rate

Answer 15

Property’s income divided by its value.

Question 16

Unique trait about timber valuations:

Answer 16

timber valuations are based on appraisals, which are smoothed (i.e., they have reduced volatilities).

Question 17

Difference between American and European options:

Answer 17

European options are only exercised at their expiration dates, so perpetual options could never be exercised if they were European options.

In contrast, American options can be exercised any time up to and at expiration.

Question 18

____ is a type of undeveloped land in which construction has begun but is not yet ready for homebuilding.

Answer 18

A blue top lot