A Practical View on Valuation of Multi-Exercise American Style Options in Gas and Electricity Markets

Abstract

American style options with multiple exercise rights play an important role in energy business, especially in gas and electricity markets where storage is limited and costly. Fluctuations in demand require flexibility in generation and such options can be a possible source of flexibility. Beneath contractual agreements also physical assets like gas storage facilities and hydro storage power plants can be seen as options and can provide flexible supply. We will give an overview of the most common option types and will describe briefly valuation methods used for industry purposes. We present some practical problems which occur when pricing multi-exercise American style options. Due to complex exercise constraints, stochastic strike prices and stochastic volume constraints classical least squares Monte Carlo methods have to be adopted. We will give an overview of different approaches and open questions. Aside from valuation, hedging and optimal exercise strategies is a second topic which we will present in detail from a practitioner's perspective. © Springer-Verlag Berlin Heidelberg 2012.