Energy-based assets: modelling, option pricing and delta hedging with transaction costs

Sovan Mitra

International Journal of Sustainable Economy, 2011, vol. 3, issue 1, 20-43

Abstract: The growing significance of climate change and carbon financing means it is becoming increasingly important to generically model energy-based assets in a more theoretically consistent and realistic approach. A fundamental feature is supply-demand imbalances and this is modelled by deterministic sinusoidal functions on multiple time scales. This is unrealistic and theoretically inconsistent with scientific and financial models. We propose a new generic model for energy-based assets using Ornstein–Uhlenbeck processes on multiple time scales, which captures supply-demand imbalances in a more theoretically consistent and realistic manner. We analyse its properties and derive closed form solutions to European option prices on the underlying spot and futures processes. We derive a closed form analytic equation for delta hedging options under transaction costs using a perturbation analysis. We conduct numerical experiments on our model by calibrating it to Nord Pool electricity data and executing Monte Carlo simulation over 10,000 sample paths.

Keywords: energy based assets; spot prices; futures prices; option on spot; futures options; delta hedging; transaction costs; perturbation analysis; climate change; carbon financing; sustainability; modelling; supply-demand imbalances; option prices; Monte Carlo simulation. (search for similar items in EconPapers)
Date: 2011
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