Pricing and Hedging of Energy Spread Options and Volatility Modulated Volterra Processes

Abstract

Abstract. We derive the price of a spread option based on two assets which follow a bivariate volatility modulated Volterra process dynamics. Such a price dynamics is particularly relevant in energy markets, modelling for example the spot price of power and gas. Volatility modulated Volterra 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.

Risk Management in Electricity Markets: Dominant Topics and Research Trends

“…On the other hand, there are works that use spread options for hedging purposes. In this sense, a modulated volatility model (Benth and Zdanowicz 2016) and a two-factor model with Levy processes (Mehrdoust and Noorani 2022) are proposed to determine the price of an electricity and gas spread option. Climate derivatives arise from the growing concern of many industries exposed to climate risk.…”