Asset Pricing in Incomplete Markets: Valuing Gas Storage Capacity

Tinbergen Institute Discussion Paper 15-104/VI/DSF95

34 Pages Posted: 8 Sep 2015

See all articles by Lin Zhao

Lin Zhao

Vrije Universiteit Amsterdam, School of Business and Economics

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: August 28, 2015

Abstract

We investigate the relationship between the gas spot market and the price of gas storage capacity. Contrary to the common belief, the auction prices for gas storage are mostly affected by the volatility of current market prices rather than by the winter-summer price differences. This paper provides a numerical solution for pricing storage capacity, by taking investor's activities through the spot market and storage service into account. A bivariate Generalized Autoregressive Score (GAS) model is employed for modeling the dynamics of the day-ahead and month-ahead spot market prices, as well as the time-varying volatilities and correlations. Under an incomplete market setting, our model is able to approximate the realized auction prices. Moreover, one interesting implication is that the implied average risk aversion of investor for a storage contract increases with the volatility of the spot market. This is an intuitive result because storage capacity can serve as an effective hedging product for the spot market, and the demand for this product is high when the market becomes risky: more risk averse investors are participating in the auctions. Moreover, a sensitivity analysis on different injection/withdrawal rates is also included, and particularly, contracts with higher capacity rates are priced at a higher level.

Keywords: stochastic volatility, Generalised Autoregressive Score modeling, incomplete markets, real options, utility indifference pricing, gas storage, capacity constraints

JEL Classification: C61, C63, G12, G13, Q41

Suggested Citation

Zhao, Lin and van Wijnbergen, Sweder, Asset Pricing in Incomplete Markets: Valuing Gas Storage Capacity (August 28, 2015). Tinbergen Institute Discussion Paper 15-104/VI/DSF95. Available at SSRN: https://ssrn.com/abstract=2653647 or http://dx.doi.org/10.2139/ssrn.2653647

Lin Zhao (Contact Author)

Vrije Universiteit Amsterdam, School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081HV
Netherlands

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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