Contingent claims on assets with conversion costs. (Q1873082)

Contingent claim contracts on natural resources which may involve assets existing in undeveloped states are studied. An undeveloped asset may become negative due to the conversion cost \(c\) given in the contracts. Pricing of such contracts involves natural arbitrage opportunities on undeveloped assets if the developed prices drop below \(c\) and then rise before expiry \(T\). The authors consider the effect on the contract price of requiring a contract settlement (with possible rebates) at the time \(\tau_c = \inf\{t\leq T: S(t) = c\}\). The final pricing equation (with knock-out boundary) is obtained. Mathematically, the success of the approach is based on the martingale localization of the classic theory of Harrison-Pliska. The particular application which serves to motivate the paper is that of pricing federal timber leases. The solution of the cost-modified equation naturally leads to an Asian-type option combined with a down and out barrier.