Energy Options in an HJM Framework
35 Pages Posted: 6 Mar 2005
Date Written: January 2005
Abstract
Options in energy markets often differ from standard options on futures by the fact that the underlying is a portfolio of futures rather than a single-delivery futures contract. Standard pricing formulas for options on single-delivery futures do not generalize to this case. There are similarities to pricing options on coupon bonds, although the number of single-delivery futures contracts in this underlying portfolio is usually much larger than the number of coupons on a coupon bond. This calls for easily implementable numerical approximations. We combine the HJM model approach in Miltersen and Schwartz (1998) with variants of the stochastic duration approach in Munk(1999) and find that this a very good approximation, in particular for at-the-money options.
Keywords: eneregy option, flow-forward-contracts, stochastic duration
JEL Classification: G13
Suggested Citation: Suggested Citation
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