Implications of alternative stochastic processes for investment in agricultural technologies

Abstract

Considerable research and analyses exist concerning applying the option value to investment decisions. A model has been developed to examine the extent to which two alternative stochastic processes, geometric Brownian motion (GBM) and mean reversion, have impacts on investment decisions. The results show that the impacts of uncertainty and irreversibility on investment decisions differ under GBM and mean reversion. Studies that assume the returns evolve as GBM without drift would overestimate the value of the investment opportunity, while they would underestimate it if they assume the returns follow GBM with drift. The magnitude of error one could make by using GBM when the returns follow mean reversion is high.

Notes

¹ The analysis could be extended to include other sources of uncertainty such as crop yields. To keep the analysis tractable and transparent, while analysing impacts of alternative stochastic processes, we focus only on price uncertainty.