Commodity-Based “Swing” Options

Ehud Ronn

One of the most complex derivative structures is a contract that exists in the commodity arena – in particular, natural-gas and electricity – which incorporates flexibility-of-delivery options. As is the case for all options with a constant strike price, they provide protection against price changes. Subject to periodic (daily or monthly) as well as aggregate constraints, they permit the option holder to repeatedly exercise the right to receive quantities of energy. Consequently, these options have an implicit dependence through time: the exercise of an option today limits, and may eliminate, the ability to draw such energy tomorrow. While these options are indeed “exotic", what renders them of specific interest is that there exists a natural raison d’être for their existence: they address the need to hedge in a market subject to frequent, but not pervasive, price-spiking behaviour typically followed by mean-reversion to normal levels. This chapter specifies the option, known as “swing” or “take-or-pay”, addresses the motivation for their existence and provides their valuation implication.

INTRODUCTION

This chapter addresses the motivation for and valuation of a complex