Real Option Valuation for Reserve Capacity

32 Pages Posted: 12 Oct 2014 Last revised: 3 Jul 2016

See all articles by John Moriarty

John Moriarty

Queen Mary University of London - School of Mathematical Sciences

Jan Palczewski

University of Leeds - School of Mathematics

Date Written: July 2, 2016

Abstract

Motivated by the potential use of electricity storage to smooth fluctuations in supply and demand, we study the problem of writing American-type call options when the holder's exercise strategy is of threshold type (so that the time of exercise is known, but random). The writer must provide physical cover by buying and storing the asset {\em before} selling the option. We optimise the writer's strategy for a single option and for an infinite sequence of options, these two strategies being different. The latter is motivated by the lifetime valuation of an energy storage unit when used as reserve capacity in a power system. Our stochastic process is a Brownian motion representing the real-time system imbalance, and which we rescale to represent an imbalance price. The single option leads to an optimal stopping problem in which the principle of smooth fit may be violated and the stopping region may be disconnected. The lifetime analysis uses techniques and results for the single option to construct a certain fixed point characterising the value function.

Keywords: American option, real option, energy balancing, capacity market

JEL Classification: C61, G12

Suggested Citation

Moriarty, John and Palczewski, Jan, Real Option Valuation for Reserve Capacity (July 2, 2016). Available at SSRN: https://ssrn.com/abstract=2508258 or http://dx.doi.org/10.2139/ssrn.2508258

John Moriarty

Queen Mary University of London - School of Mathematical Sciences ( email )

School of Mathematical Sciences
Mile End Road
London, E1 4NS
United Kingdom

Jan Palczewski (Contact Author)

University of Leeds - School of Mathematics ( email )

Leeds, LS2 9JT
United Kingdom

HOME PAGE: http://www.maths.leeds.ac.uk/~jp

Register to save articles to
your library

Register

Paper statistics

Downloads
223
Abstract Views
900
rank
137,046
PlumX Metrics