ETLA Discussion Papers, The Research Institute of the Finnish Economy (ETLA) 840
The current literature on optimal forest rotation makes the unrealistic assumption of constant interest rate though harvesting decisions of forest stands are typically subject to relatively long time horizons. We apply the single rotation framework to extend the existing studies to cover the unexplored case of variable interest rate. We show that even in the deterministic case if the current interest rate deviates from its long-run steady state, interest rate variability may change the rotation age significantly when compared with the constant discounting case. Further, and importantly, allowing for interest rate uncertainty as a mean reverting process and forest value as a geometric Brownian motion we can provide an explicit solution for the two dimensional path-dependent optimal stopping problem. Increased interest rate volatility is shown to lengthen the optimal rotation period. Numerical calculations show that interest rate volatility has a big quantitative importance.