Affiliations: Exelon Corporation, Kennett Square, PA, USA | INSEAD, Paris, France
Note: [] Corresponding author: Lide Li, 300 Exelon Way, Kennett Square, PA 19348, USA. E-mail: [email protected]
Note: [] Paul Robert Kleindorfer (1940–2012) passed away in Paris, France, on August 24th, 2012 after a struggle with ALS.
Abstract: Calendar options are effective hedging tools in energy markets. They are widely used by market participants such as power generation companies, energy producers, banks and speculators. Notwithstanding the importance of calendar options (or in their usual form “swaptions”) in the energy market for risk management in practice, little has been written about their integration with energy portfolio theory and their implications for risk management strategies. As limited market information about calendar options is available compared with more liquid monthly and daily options, the related valuation and risk analysis becomes challenging. In this paper we introduce various types of options in the power markets, and provide a process to value the calendar options under the assumption that the market information for monthly options is available and the “monthly shocks” follow an ARMA process. We also provide a real example to demonstrate how a calendar option is valued. In the course of achieving the main result in this paper, the key step is to prove a proposition which itself could have general applications for some time series related problems. It solves the correlation problem between any two random terms in an ARMA process, as defined in the paper.
Keywords: Calendar option, energy market, swaption, ARMA, correlation, hedge
