Valuation of Commodity-Based Swing Options

In the energy markets, in particular the electricity and natural gas markets, many contracts incorporate flexibility-of-delivery options known as "swing" or "take-or-pay" options. Subject to daily as well as periodic constraints, these contracts permit the option holder to repeatedly exercise the right to receive greater or smaller amounts of energy. We extract market information from forward prices and volatilities and build a pricing framework for swing options based on a one-factor mean-reverting stochastic process for energy prices that explicitly incorporates seasonal effects. We present a numerical scheme for the valuation of swing options calibrated for the case of natural gas.

[1]  John Parker.  A RUTHLESS BUSINESS , 2000 .

[2]  C Ham,et al.  Getting into the swing. , 1999, Health Service Journal.

[3]  D. Pilipović,et al.  Energy Risk: Valuing and Managing Energy Derivatives , 1997 .

[4]  Olivier Scaillet,et al.  Convergence of discrete time option pricing models under stochastic interest rates , 2000, Finance Stochastics.

[5]  John C. Hull,et al.  Numerical Procedures for Implementing Term Structure Models II , 1994 .

[6]  Eduardo S. Schwartz,et al.  Short-Term Variations and Long-Term Dynamics in Commodity Prices , 2000 .

[7]  A. C. Thompson.  Valuation of Path-Dependent Contingent Claims with Multiple Exercise Decisions over Time: The Case of Take-or-Pay , 1995, Journal of Financial and Quantitative Analysis.

[8]  M. Manoliu,et al.  Energy futures prices: term structure models with Kalman filter estimation , 2002 .

[9]  Shi-Jie Deng,et al.  Pricing electricity derivatives under alternative stochastic spot price models , 2000, Proceedings of the 33rd Annual Hawaii International Conference on System Sciences.

[10]  Eduardo S. Schwartz,et al.  Stochastic Convenience Yield and the Pricing of Oil Contingent Claims , 1990 .

[11]  Alan G. White,et al.  Efficient Procedures for Valuing European and American Path-Dependent Options , 1993 .

[12]  Ravi Anupindi,et al.  Supply Contracts with Quantity Commitments and Stochastic Demand , 1999 .

[13]  Paul L. Joskow,et al.  Vertical integration and long term contracts : the case of coal burning electric generating plants , 1985 .

[14]  B. J. Hiley,et al.  Getting into the swing , 1990, Nature.

[15]  Eduardo S. Schwartz.  The stochastic behavior of commodity prices: Implications for valuation and hedging , 1997 .

[16]  P. Joskow.  Contract duration and relationship-specific investments: Empirical evidence from coal markets , 1987 .