Risk Valuation of Quanto Derivatives on Temperature and Electricity

Aurélien Alfonsi and Nerea Vadillo

Applied Mathematical Finance, 2023, vol. 30, issue 6, 275-312

Abstract: This paper develops a coupled model for day-ahead electricity prices and average daily temperature which allows to model quanto weather and energy derivatives. These products have gained on popularity as they enable to hedge against both volumetric and price risks. Electricity day-ahead prices and average daily temperatures are modelled through nonhomogeneous Ornstein–Uhlenbeck processes driven by a Brownian motion and a Normal Inverse Gaussian Lévy process, which allows to include dependence between them. A Conditional Least Square method is developed to estimate the different parameters of the model and used on real data. Then explicit and semi-explicit formulas are obtained for derivatives including quanto options and compared with Monte Carlo simulations. Last, we develop explicit formulas to hedge statically single- and double-sided quanto options by a portfolio of electricity options and temperature options (CDD or HDD).

Date: 2023
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DOI: 10.1080/1350486X.2024.2356554

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