Quotation Löhndorf, Nils, Wozabal, David. 2017. Indifference pricing of natural gas storage contracts.


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Abstract

Natural gas markets are incomplete due to physical limitations and low liquidity, but most valuation approaches for natural gas storage contracts assume a complete market. We propose an alternative approach based on indifference pricing which does not require this assumption but entails the solution of a high- dimensional stochastic-dynamic optimization problem under a risk measure. To solve this problem, we develop a method combining stochastic dual dynamic programming with a novel quantization method that approximates the continuous process of natural gas prices by a discrete scenario lattice. In a computational experiment, we demonstrate that our solution method can handle the high dimensionality of the optimization problem and that solutions are near-optimal. We then compare our approach with rolling intrinsic valuation, which is widely used in the industry, and show that the rolling intrinsic value is sub-optimal under market incompleteness, unless the decision-maker is perfectly risk-averse. We strengthen this result by conducting a backtest using historical data that compares both trading strategies. The results show that up to 40% more profit can be made by using our indifference pricing approach.

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Publication's profile

Status of publication Published
Affiliation WU
Type of publication Working/discussion paper, preprint
Language English
Title Indifference pricing of natural gas storage contracts.
Year 2017
URL http://www.optimization-online.org/DB_FILE/2017/02/5863.pdf

Associations

People
Löhndorf, Nils (Former researcher)
External
Wozabal, David (Technische Universität München, Germany)
Organization
Produktionsmanagement (Taudes) (Details)
Research areas (ÖSTAT Classification 'Statistik Austria')
1121 Operations research (Details)
2919 Energy research (Details)
5360 Financial mathematics (Details)
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