S.D. Hodges (UK)
real options, storage, option to store, local time.
The paper derives the value of a storage facility that is too small to affect an exogenously defined price process of a storable good with seasonal and mean-reverting components. It provides an elegant new continuous-time model of storage under simple assumptions, which could be applied, for example, to natural gas. In the case without a seasonal component, closed form solutions are obtained as functions of the underlying price. A local time analysis provides an even simpler unconditional formula, which generalises to the full model. The value of a storage facility under a model with a seasonal and a stochastic component is represented as a time integral which is easily evaluated numerically. The analysis provides a proper treatment of the true nature of the "option to store". An interesting feature of the model is that all transactions (whether to buy or to sell) are triggered by a single critical price. The analysis enables us to compare the profitability of storing under alternative price process assumptions.
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