Risk hedging in storage grid markets: Do options add value to forwards?

Abstract

Internet storage services allow businesses to move away from maintaining their own internal storage networks. Service providers currently follow a utility pricing model which translates to them absorbing all the risk that arises from the fluctuating storage needs of their customers. The risk borne by the Internet storage service providers has large revenue implications as Internet startups and smaller companies, which face significant demand stochasticity, constitute an important segment of their clientele. We develop an option pricing mechanism to hedge against this risk and evaluate its effectiveness vis-à-vis forward contracts. We obtain the conditions under which options dominate forward contracts and the trade-offs involved when the provider has to decide on appropriate pricing mechanisms. Our empirical study uses publicly obtainable traffic data of Amazon S3 clients to validate the analytical results. We show that providers can significantly benefit from including options in their risk-hedging portfolio, especially when there is less variation in the costs faced by the buyers in building their own data networks as opposed to using cloud services.