A Supply and Demand Based Volatility Model for Energy Prices - the Relationship between Supply Curve Shape and Volatility

This paper proposes a new volatility model for energy prices explicitly characterized by the supply-demand relationship, which we call a Supply and Demand based Volatility (SDV) model. We show that the supply curve shape of energy in the SDV model produces the characteristics of the volatility in energy prices. Especially, it is found that the inverse Box-Cox transformation supply curve reflecting energy markets appropriately causes the inverse leverage effect often seen in the markets. The SDV model is also used to show that an existing (G)ARCH-M model has foundation on the supply-demand relationship. In addition, we conduct the empirical studies analyzing the volatility in the U.S. natural gas prices