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Valuation of Commodity-Based Swing Options

Author

Listed:
  • Patrick Jaillet

    () (Department of Civil and Environmental Engineering, 77 Massachusetts Avenue, Building 1-290, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139)

  • Ehud I. Ronn

    () (Department of Finance, McCombs School of Business, University of Texas at Austin, 1 University Station, B6600, Austin, Texas 78712-1179)

  • Stathis Tompaidis

    () (MSIS Department, McCombs School of Business, University of Texas at Austin, 1 University Station, B6500, Austin, Texas 78712-1175)

Abstract

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.

Suggested Citation

  • Patrick Jaillet & Ehud I. Ronn & Stathis Tompaidis, 2004. "Valuation of Commodity-Based Swing Options," Management Science, INFORMS, vol. 50(7), pages 909-921, July.
  • Handle: RePEc:inm:ormnsc:v:50:y:2004:i:7:p:909-921
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    File URL: http://dx.doi.org/10.1287/mnsc.1040.0240
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    References listed on IDEAS

    as
    1. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, vol. 46(7), pages 893-911, July.
    2. Joskow, Paul L, 1985. "Vertical Integration and Long-term Contracts: The Case of Coal-burning Electric Generating Plants," Journal of Law, Economics, and Organization, Oxford University Press, vol. 1(1), pages 33-80, Spring.
    3. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-973, July.
    4. 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 959-976, July.
    5. Thompson, Andrew C., 1995. "Valuation of Path-Dependent Contingent Claims with Multiple Exercise Decisions over Time: The Case of Take-or-Pay," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(02), pages 271-293, June.
    6. O. Scaillet & J.-L. Prigent & J.-P. Lesne, 2000. "Convergence of discrete time option pricing models under stochastic interest rates," Finance and Stochastics, Springer, vol. 4(1), pages 81-93.
    7. Joskow, Paul L, 1987. "Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets," American Economic Review, American Economic Association, vol. 77(1), pages 168-185, March.
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