Thomas Lyse Hansen

Energy Options in an HJM Framework

Abstract

Options in energy markets often differ from standard options on futures
by the fact that the underlying is a portfolio of futures rather than
a single-delivery futures contract. Standard pricing formulas for
options on single-delivery futures do not generalize to this
case. There are similarities to pricing options on coupon bonds,
although the number of single-delivery futures contracts in this
underlying portfolio is usually much larger than the number of coupons
on a coupon bond. This calls for easily implementable numerical
approximations. We combine the HJM model approach in Miltersen and
Schwartz (1998) with variants of the stochastic duration approach in
Munk(1999) and find that this a very good approximation, in particular
for at-the-money options.