Cutting edge: Valuation and optimal hedging of storage contracts in incomplete gas markets

Gas storage

Cyclical gas consumption, as well as limited and lagged adjustments of gas supply (for example, caused by increased production), lead to drastic price movements with uncertain volumes. As a suitable means to hedge against those uncertainties, virtual and physical gas storage contracts are becoming more and more important (see Eydeland & Wolyniec (2013) for market fundamentals, as well as standard pricing and hedging approaches).

However, a market-coherent valuation and replication of these contracts can be restricted due to the fact that the gas market is incomplete – that is, the underlying risks are not fully traded. As an example, the daily spot market risk cannot be hedged (or replicated) because futures cannot be traded on a daily basis.

Hence, it is often not possible to fully replicate a given bilateral contract using a combination of instruments traded in the futures or option markets. As a result, spot market risks will remain with the hedger regardless of the exact hedging strategy.

Real option approaches, although frequently used by practitioners, often do not account for this restricted replicability and are highly demanding in terms of actual numerical calculations. Hence, an efficient numerical valuation framework that overcomes the fallacies and issues caused by incomplete markets is required.

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