Valuation and hedging efficiency of multifactor swing quanto options for price-volume risk in electricity markets

A quanto option is a type of multivariate option whose payoff is determined by the product of a standard option and a stochastic multiplier such as trading volume. In this study, we extend this concept to swing options, which allow multiple exercises within a specified period, and introduce the ‘multifactor swing quanto option' to mitigate cash flow fluctuation risks driven by the product of price and volume in electricity markets. First, we model the underlying asset prices and volume indices using deterministic time trends and vector autoregressive (VAR) processes. The least-squares Monte Carlo (LSMC) method is then applied to compute option prices based on generated sample paths and estimated continuation value functions, with tensor product spline basis functions enhancing flexibility in multidimensional modeling. To assess the hedging performance of the proposed swing quanto option, we conduct numerical experiments using Japanese electricity market data, including Japan Electric Power Exchange (JEPX) spot prices and area demand. Conventional comparisons indicate that swing quanto options achieve better hedging performance than European quanto options; however, this advantage may simply reflect their higher initial cost. To examine cost-effectiveness, we adjust the holding quantity of swing quanto options to match the initial cost of European quanto options and compare their hedging performance under an equal investment constraint. Even after this adjustment, swing quanto options still provide superior loss-risk mitigation, demonstrating greater cost-effectiveness. This also suggests that the flexibility in selecting exercise timing, while inherently valuable, enables effective hedging even when its associated cost is reduced.