PRICING AND HEDGING OF ENERGY SPREAD OPTIONS AND VOLATILITY MODULATED VOLTERRA PROCESSES

Fred Espen Benth and Hanna Zdanowicz ()
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Fred Espen Benth: Department of Mathematics, University of Oslo, P.O. Box 1053, Blindern, N-0316 Oslo, Norway2Centre of Advanced Study, Drammensveien 78, N-0271 Oslo, Norway
Hanna Zdanowicz: Department of Mathematics, University of Oslo, P.O. Box 1053, Blindern, N-0316 Oslo, Norway

International Journal of Theoretical and Applied Finance (IJTAF), 2016, vol. 19, issue 01, 1-22

Abstract: We derive the price of a spread option based on two assets which follow a bivariate volatility modulated Volterra (VMV) process dynamics. Such a price dynamics is particularly relevant in energy markets, modeling for example the spot price of power and gas. VMV processes are in general not semimartingales, but contain several special cases of interest in energy markets, like for example continuous-time autoregressive moving average processes. Based on a change of measure, we obtain a pricing expression based on a univariate Fourier transform of the payoff function and the characteristic function of the price dynamics. Moreover, the spread option price can be expressed in terms of the forward prices on the underlying dynamics assets. We compute a linear system of equations for the quadratic hedge for the spread option in terms of a portfolio of underlying forward contracts.

Keywords: Spread option; measure change; Lévy semistationary process; volatility modulated volterra process; quadratic hedging; energy markets (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024916500023

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