Abstract
A typical gas swing contract is an agreement between a supplier and a purchaser for the delivery of variable daily quantities of gas, between specified minimum and maximum daily limits, over a certain period at a specified set of contract prices. The main constraint of such an agreement that makes them difficult to value are that there is a minimum volume of gas (termed take-or-pay or minimum bill) for which the buyer will be charged at the end of the period (or penalty date), regardless of the actual quantity of gas taken. We propose a framework for pricing such swing contracts for an underlying gas forward price curve that follows a regime-switching process in order to better capture the volatility behavior in such markets. With the help of a recombining pentanomial tree, we are able to efficiently evaluate the prices of the swing contracts and find optimal daily decisions in different regimes. We also show how the change of regime will affect the decisions.
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Notes
- 1.
Chiarella et al. [8] suggest a two-factor regime-switching forward curve model. However, for simplicity and for the purpose of demonstrating the implementation of the pentanomial tree approach we use a one-factor model here. We also argue that a multifactor model is necessary for hedging and risk management purposes a one-factor model is a good approximation for pricing. Also, it is not hard to generalize the approach in the paper to handle two or more factor models but the computational effort will of course increase.
- 2.
This ratio needs to be adjusted accordingly if we have N > 2 regimes, see [14] for more details.
- 3.
The determination of l depends on the different alternative branching processes for the mean reverting processes. For instance, in Fig. 3, from left to right, l is equal to k − 2, k − 1, k, k + 1, and k + 2, respectively.
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Chiarella, C., Clewlow, L., Kang, B. (2012). The Evaluation of Gas Swing Contracts with Regime Switching. In: Cummins, M., Murphy, F., Miller, J. (eds) Topics in Numerical Methods for Finance. Springer Proceedings in Mathematics & Statistics, vol 19. Springer, Boston, MA. https://doi.org/10.1007/978-1-4614-3433-7_9
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DOI: https://doi.org/10.1007/978-1-4614-3433-7_9
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