energy

Introduction Intrinsic value is a well defined and often used concept of option pricing theory. It is usually defined as the maximum of zero and the value the option would have if it were exercised immediately. This definition is straightforward to apply to vanilla option with single exercise decision, but its application to more complex options traded in energy markets (e.g. natural gas storage or power tolling) might be confusing. In this blog post we will develop intuition behind the definition of intrinsic value that will help us understand its importance and application to complex options.

Summary The modelling of spot (daily) prices in commodities usually starts with modelling monthly average (forward) prices and then selecting some simple model to describe daily prices within the month relative to the monthly average. The most common model is a simple Geometric Brownian Motion with constant (spot) volatility. In this blog post we show that this approach results in wrong interdependencies (autocorrelation) in spot prices. We tested two other popular approaches:

Summary When computing a monthly strip of daily options it is never a good idea to approximate it with a daily option expiring in in the middle of the month (15'th day) as errors in value or implied volatility can be as high as 4%. Instead, it is better to take the daily option that expires after 13.9 days within a month (this halves the errors of the previous method). An even better approach would be to take option that expires depending on how far is the delivery month T - with this method the errors are reduced by a factor of 10 (0.