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Pricing Options On Forwards In Energy Markets: The Role Of Mean Reversion'S Speed

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  • MAREN DIANE SCHMECK

    (Center for Mathematical Economics, Bielefeld University, Universitätsstraße 25, D-33615 Bielefeld, Germany)

Abstract

Consider the problem of pricing options on forwards in energy markets, when spot prices follow a geometric multi-factor model in which several rates of mean reversion appear. In this paper, we investigate the role played by slow mean reversion when pricing and hedging options on forwards. In particular, we determine both upper and lower bounds for the error one makes neglecting low rates of mean reversion in the spot price dynamics in a jump diffusion setting. When including stochastic volatility as well as time dependent mean reversion into the model, we quantify a bound for the maximum error one makes.

Suggested Citation

  • Maren Diane Schmeck, 2016. "Pricing Options On Forwards In Energy Markets: The Role Of Mean Reversion'S Speed," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(08), pages 1-26, December.
    • Handle: RePEc:wsi:ijtafx:v:19:y:2016:i:08:n:s0219024916500539
    DOI: 10.1142/S0219024916500539
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    Cited by:

    1. Piccirilli, Marco & Schmeck, Maren Diane & Vargiolu, Tiziano, 2021. "Capturing the power options smile by an additive two-factor model for overlapping futures prices," Energy Economics, Elsevier, vol. 95(C).
    2. Deschatre, Thomas & Féron, Olivier & Gruet, Pierre, 2021. "A survey of electricity spot and futures price models for risk management applications," Energy Economics, Elsevier, vol. 102(C).
    3. Borovkova, Svetlana & Schmeck, Maren Diane, 2017. "Electricity price modeling with stochastic time change," Energy Economics, Elsevier, vol. 63(C), pages 51-65.
    4. Kemper, Annika & Schmeck, Maren Diane & Kh.Balci, Anna, 2022. "The market price of risk for delivery periods: Pricing swaps and options in electricity markets," Energy Economics, Elsevier, vol. 113(C).
    5. Kemper, Annika & Schmeck, Maren Diane & Khripunova Balci, Anna, 2020. "The Market Price of Risk for Delivery Periods: Pricing Swaps and Options in Electricity Markets," Center for Mathematical Economics Working Papers 635, Center for Mathematical Economics, Bielefeld University.
    6. Thomas Deschatre & Olivier F'eron & Pierre Gruet, 2021. "A survey of electricity spot and futures price models for risk management applications," Papers 2103.16918, arXiv.org, revised Jul 2021.
    7. Maren Diane Schmeck & Stefan Schwerin, 2021. "The Effect of Mean-Reverting Processes in the Pricing of Options in the Energy Market: An Arithmetic Approach," Risks, MDPI, vol. 9(5), pages 1-19, May.

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