PRICING OPTIONS ON FORWARDS IN ENERGY MARKETS: THE ROLE OF MEAN REVERSION'S SPEED

Maren Diane Schmeck ()
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Maren Diane Schmeck: Center for Mathematical Economics, Bielefeld University, Universitätsstraße 25, D-33615 Bielefeld, Germany

International Journal of Theoretical and Applied Finance (IJTAF), 2016, vol. 19, issue 08, 1-26

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.

Keywords: Electricity spot prices; multi-scale mean reversion; jumps; stochastic volatility; delivery period; options on forwards; hedging; pricing error; upper and lower bounds (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (9)

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DOI: 10.1142/S0219024916500539

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