Semianalytical Pricing and Hedging of Fixed and Indexed Energy Swing Contracts

Typical natural gas derivative contracts in the wholesale market contain several multifaceted flexibilities, which protect buyers from fluctuations in price and demand. We will focus on fair market valuation as well as hedging of the most common type of these contracts: swing options. We follow the ideas of a seminal 2004 article by Keppo and decompose swing contracts into tradable products. While Keppo considers only forwards and call options to decompose the flexibility in a fixed swing contract, we add time-spread optionality. Moreover, we extend Keppo’s decomposition approach to cover indexed swing contracts. To this end, we introduce a simple spot price model and use reasonable approximations to account for the indexed swing’s inherent Asian optionality. In contrast to standard least- square Monte Carlo valuation techniques, which are limited by increasing memory constraints, our heuristic valuation approach allows for an arbitrary number of period volume constraints of the swing contract. Further, our approach can deal with 100% take-or-pay contracts, which are typically not covered by Keppo-like valuation methods, and we will derive and backtest analytical approximations for the swing contract’s Greeks.