Enhancing Least Squares Monte Carlo with diffusion bridges: an application to energy facilities

T. Pellegrino and P. Sabino

Quantitative Finance, 2015, vol. 15, issue 5, 761-772

Abstract: The aim of this study is to present an efficient and easy framework for the application of the Least Squares Monte Carlo methodology to the pricing of gas or power facilities as detailed in Boogert and de Jong [ J. Derivatives , 2008, 15 , 81-91]. As mentioned in the seminal paper by Longstaff and Schwartz [ Rev. Financ. Stud. 2001, 113-147], the convergence of the Least Squares Monte Carlo algorithm depends on the convergence of the optimization combined with the convergence of the pure Monte Carlo method. In the context of the energy facilities, the optimization is more complex and its convergence is of fundamental importance in particular for the computation of sensitivities and optimal dispatched quantities. To our knowledge, an extensive study of the convergence, and hence of the reliability of the algorithm, has not been performed yet, in our opinion this is because the apparent infeasibility and complexity uses a very high number of simulations. We present then an easy way to simulate random trajectories by means of diffusion bridges in contrast to Dutt and Welke [ J. Derivatives , 2008, 15 (4), 29-47] that considers time-reversal Itô diffusions and subordinated processes. In particular, we show that in the case of Cox-Ingersoll-Ross and Heston models, the bridge approach has the advantage to produce exact simulations even for non-Gaussian processes, in contrast to the time-reversal approach. Our methodology permits performing a backward dynamic programming strategy based on a huge number of simulations without storing the whole simulated trajectory. Generally, in the valuation of energy facilities, one is also interested in the forward recursion. We then design backward and forward recursion algorithms such that one can produce the same random trajectories by the use of multiple independent random streams without storing data at intermediate time steps. Finally, we show the advantages of our methodology for the valuation of virtual hydro power plants and gas storages.

Date: 2015
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Citations: View citations in EconPapers (11)

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DOI: 10.1080/14697688.2014.941913

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