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Valuing Energy Options in a One Factor Model Fitted to Forward Prices

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  • Les Clewlow
  • Chris Strickland
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    Abstract

    In this paper we develop a single-factor modeling framework which is consistent with market observable forward prices and volatilities. The model is a special case of the multi-factor model developed in Clewlow and Stickland [1999b] and leads to analytical pricing formula for standard options, caps, floors, collars and swaptions. We also show how American style and exotic energy derivatives can be priced using trinomial trees, which are constructed to be consistent with the forward curve and volatility structure. We demonstrate the application of the trinomial tree to the pricing of a European and American Asian option. The analysis in this paper extends the results in Schwartz [1997] and Amin, et al. [1995].

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    File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp10.pdf
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    Bibliographic Info

    Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 10.

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    Date of creation: 01 Apr 1999
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    Handle: RePEc:uts:rpaper:10

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    1. Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
    2. Gibson, Rajna & Schwartz, Eduardo S, 1990. " Stochastic Convenience Yield and the Pricing of Oil Contingent Claims," Journal of Finance, American Finance Association, vol. 45(3), pages 959-76, July.
    3. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    5. Amin, Kaushik I. & Jarrow, Robert A., 1991. "Pricing foreign currency options under stochastic interest rates," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 310-329, September.
    6. Kaushik I. Amin & Robert A. Jarrow, 1992. "Pricing Options On Risky Assets In A Stochastic Interest Rate Economy," Mathematical Finance, Wiley Blackwell, vol. 2(4), pages 217-237.
    7. Cox, John C. & Ingersoll, Jonathan Jr. & Ross, Stephen A., 1981. "The relation between forward prices and futures prices," Journal of Financial Economics, Elsevier, vol. 9(4), pages 321-346, December.
    8. Hilliard, Jimmy E. & Reis, Jorge, 1998. "Valuation of Commodity Futures and Options under Stochastic Convenience Yields, Interest Rates, and Jump Diffusions in the Spot," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(01), pages 61-86, March.
    9. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
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    Cited by:
    1. Joanna Janczura, 2014. "Pricing electricity derivatives within a Markov regime-switching model: a risk premium approach," Computational Statistics, Springer, vol. 79(1), pages 1-30, February.
    2. Fleten, Stein-Erik & Lemming, Jacob, 2003. "Constructing forward price curves in electricity markets," Energy Economics, Elsevier, vol. 25(5), pages 409-424, September.
    3. Dempster, M.A.H. & Medova, Elena & Tang, Ke, 2008. "Long term spread option valuation and hedging," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2530-2540, December.
    4. Golbeck, Steven & Linetsky, Vadim, 2013. "Asset financing with credit risk," Journal of Banking & Finance, Elsevier, vol. 37(1), pages 43-59.
    5. Joanna Janczura & Aleksander Weron, 2008. "Modelling energy forward prices," HSC Research Reports HSC/08/03, Hugo Steinhaus Center, Wroclaw University of Technology.
    6. Chantziara, Thalia & Skiadopoulos, George, 2008. "Can the dynamics of the term structure of petroleum futures be forecasted? Evidence from major markets," Energy Economics, Elsevier, vol. 30(3), pages 962-985, May.
    7. Nomikos, Nikos K. & Soldatos, Orestes A., 2010. "Modelling short and long-term risks in power markets: Empirical evidence from Nord Pool," Energy Policy, Elsevier, vol. 38(10), pages 5671-5683, October.

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