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Hedging Electricity Swing Options in Incomplete

Markets
Phebe Vayanos and Daniel Kuhn
Presented by: Arash Gourtani
School of Mathematics
University of Southampton

Feb, 2011

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Abstract
In a liberalized electricity market,Public Utilities (PUs) are
vulnerable to high volatility of electricity spot prices.This problem
is presented in this paper as follow:
Swing Options have been introduced as a tool to deal with the
risk involve with the spikes in the spot price of the electricity,
where the option holder can buy electric energy from option
writer at a fixed price, during a prescribed time period.
Options non-arbitrage price interval is then determined by
hedging its payoff stream with basic market securities

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Summary

Introduction and Background

Mathematical Formulation
Solution Algorithm

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Spot Price of the Electricity

The high volatility and frequent spikes in the Spot price is due to:
Unpredictable demand
Limited storability of electricity
PUs buy energy at an uncertain wholesale price and sell it to end
customers at a fixed retail price.
Regulated Markets: government set the prices that allow PUs
to recover their costs
Vs
Liberalized Markets:Such compensations not available and
PUs hedge the risk by investing in market traded electricity
derivatives such as options, forward contract and futures.
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Electricity Market Derivatives

Forward Contracts:
Obligation to buy electric energy at a prescribed delivery rate
over a prescribed delivery period at a predetermined unit price.
Poor hedging instrument for PUs as they dont provide any
flexibility in the Volume and Timing of the energy delivery
Swing Options:
Agreement to buy and/or sell electric energy during a fixed
period of time and at a predetermined strike price
Like European call option, Swing option offer some flexibility
in both timing and the volume of energy delivery.
It can only be exercised a limited number of times
Illustrative example: Swing option may allow holder to
purchase between 500 and 1000 MWh of electric energy at a
unit price of 60/MWh during the next month, while no more
than 50 MWh maybe bought on each day
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An Arbitrage-Free Market

Arbitrage is a situation where by combining two or more

financial products we make an investment that is guaranteed
to yield a profit with no investment or cost with absolute
certainty (making money without any risk of investment)
We assume the market of basic securities (i.e cash as well as
forwards and European Options on energy) is arbitrage-free
This assumption is the key concept in valuation and pricing
derivative in the market

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Swing Option Pricing in Incomplete Market

The market should remain arbitrage-free when the swing option is
added to existing investment opportunities (No-arbitrage pricing):
This price is unique if there exist a (replicating) portfolio of
basic securities that generates, with certainty, the same cash
flow stream as option (Complete Market)
However such a perfect option replication is not possible in
real world (Market is Incomplete) due to:
Spiky behavior of spot price
High transaction cost
Market illiquidity

Pricing framework of swing option in incomplete market

allows for an interval of option prices, which preserves
arbitrage-freeness (Instead of a single option price)
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No-Arbitrage Price Bounds

This price interval is determined by investigating two
complementary hedging portfolios of basic securities.
Lower Bound (Holders Price):
Maximum amount of money borrowed today that the option
holder can repay through exercising the option and trading in
the basic securities.
Upper Bound (Writers Price):
Minimum amount of money borrowed today that enables the
option writer to cover all obligations arising from the option
by trading in the basic securities.

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Problem Formulation

Finite planning horizon consist of T time intervals:

T = 1, ..., T
Aim is to find the value of swing option at the beginning of
the first period
Security prices and dividends as random variables defined on
probability space: (, F, P)

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Problem Formulation

Assume that elements of sample space can be represented

as = (1 , ..., T +1 ), and subvector t Rk , t T , is
observed at the beginning of period t, while T +1 is observed
at the end of the period T
Note: 1 is known today and therefore not random
Assume that is the smallest closed set that satisfies
P( ) = 1 and is bounded
Denote t = (1 , ...., t ) Rtk the history of the observation
up to period t.

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Swing Option
Strike Price: K and fixed delivery period {t, ..., t }, where
t, t T .
At the beginning of each period t {t, ..., t }, the option
holder can select the amount of energy et to be delivered in
that period (with upper and lower limits et , e t ).
Cumulative energy delivered during entire period has upper
and lower limits:
t
X
c
et c
t=t

Assume (t, t ) = (1, T ) by setting et = 0 for all elements of

subset {t T \{t, ..., t }}
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Market Model
We consider energy market consisting of a Spot Exchange and:
There are J basic securities indexed by j = 1, ..., J
St (t ) denotes the average spot price of the electricity over
period t
Ptj (t ) denotes price of security j at the beginning of period t
PTj +1 (t ) denotes price of security j at the end of period T
dtj (t ) denotes the random dividend security j pays off at the
beginning of period t
We assume that St , Ptj and djt are continuous function of
random variable t observed in period t
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Market Model cont.

Security j = 1 is riskless (e.g. a money market account) and

we assume that the interest rate is zero:
Pt1 (t ) = 1 and dt1 (t ) = 0,
The other securities represent forwards and options on
electricity whose dividend reflect the exercise costs and the
revenues generated by selling the delivered electricity on spot
market
We notationally supress the dependence on t and have
vectors Pt = (Pt1 , ..., PtJ ) and dt = (dt1 , ..., dtJ )

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Market Model Assumptions

1

Market is arbitrage-free; if that was not the case, participants

could make infinite profit with no risk

No transaction costs in trading basic securities; model is

adoptable to accommodate linear transaction costs.

Market participants are price-takers.i.e. their trade do not

affect the market prices.

We then add Swing option to the set of existing securities, with

the aim to determine the interval of swing option price that
preserve arbitrage-freeness of the market.
The holders and the writers price are representable as optimal
values of robust control problem (Bounds for the interval)
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Holders Problem

Market is arbitrage-free; if that was not the case, participants

could make infinite profit with no risk

No transaction costs in trading basic securities; model is

adoptable to accommodate linear transaction costs.

Market participants are price-takers.i.e. their trade do not

affect the market prices.

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Cournot-Nash Equilibrium

Nash-Equilibrium (x1 C , x2 C ) :
x1 C = x1 R (x2 C )
x2 C = x2 R (x1 C )

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Stackelberg-Nash Equilibrium
Stackelberg Duopoly:where x1 is the leader and x2 is the follower
Sequential quantity competition :

followers reaction function (second stage)

x2 R (x1 ) = arg max 2 (x1 , x2 )
x2

Leaders Optimal quantity (first stage):

x1 S = arg max 1 (x1 , x2 R (x1 ))
x1

Nash Equilibrium : (x1 S , x2 R )

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Problem Formulation

Description of the market

N+1 firms : i = 0, ..., N where 0 is Leader and the rest
followers
M demand scenarios : j = 1, ..., M
qi indicates production level of firm i
Total cost function: fi (qi ) is assumed to be Convex and Twice
Differentiable (A1)
Inverse demand function : pj (Q) gives the price at which
consumer will demand quantity Q in demand scenario j

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Assumptions
Model Assumptions:
1

fi (qi ) is assumed to be Convex and twice differentiable

pj (Q) functions assumed to be twice differentiable and

following equality hold (concave and decreasing Demand
Functions):
0

00

pj (Q) + Qpj (Q) 0, Q 0, j = 1, ..., M

3

(1)

there is an maximum quantity of output for each suppliers:

0

qu s.t. fi (q) pj (q), q qu,

(2)

j = 1, ..., M, i = 0, ..., N

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Original (deterministic) SNC equilibrium

In any demand scenario j:

For a given x 0 let [q1 (x), ..., qN (x)] be a set of quantities
such that for each individual i = 1, .., N, assuming that
qk (x), k 6= i are fixed, it turns out that qi = qi (x) solves the
following solves COURNOT PROBLEM:



X 
CPi (x) := max qi pi qi + x +
qk fi (qi )
(3)
qi 0

k6=i

P
where the Q(x) = N
i=1 qi (x) is the aggregate reaction
function of followers.

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Original (deterministic) SNC equilibrium

) is said to be SNC
Then a set of quantities (x , q1 , ..., qN

equilibrium if x solves the STACKELBERG PROBLEM :

 


SP := max xp x + Q(x) f0 (x)
(4)
x0

(q1 , ..., qN
) = (q1 (x ), ..., qN (x ))

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Stochastic SNC equilibrium

In order to take into account demand uncertainty (defined by M
scenarios) the model is generalized as follow:
Stochastic Cournot Problem (as many problems as scenarios):



X 
CPij (x) := max qij pi qij + x +
qkj fi (qij )
(5)
qij 0

k6=i

the aggregate reaction function of the followers for a given

decision of Leader, x, for scenario j is then:
Qj (x) =

N
X

qij (x), j = 1, ..., M

(6)

i=1

Stochastic Stackelberg Problem (Maximization of Leaders

Profit)
 X

M


SP := max x
j pj x + Qj (x) f0 (x)
(7)
x0

j=1

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Existence and Uniqueness of Joint Reaction Curves

Theorem 1
For each fixed x 0, in scenario j, there exist a unique set of
quantities [q1j (x), ..., qNj (x)] satisfying Cournot condition
cpij (x).

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Existence and Uniqueness of Joint Reaction Curves

Theorem 1
For each fixed x 0, in scenario j, there exist a unique set of
quantities [q1j (x), ..., qNj (x)] satisfying Cournot condition
cpij (x).
Proof
Each of the problem cpi (x) defined in (3) involves the
maximization of a strictly concave objective function, over the
close interval of [0, qu] (Assumption3) .Hence a unique
optimum exist.

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Aggregate Reaction Curves

Theorem 2
For every scenario j the aggregate reaction curve Qj (x) :
i) is continuous function of x
ii) verifies the following inequalities:
0

1 Qj (x) < 0, ifQj (x) > 0

0
Qj (x) = 0,
ifQj (x) = 0

(8)

i.e if Leader increases his output by 1 unit the followers globally

decrease their production by no more than 1 unit

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Aggregate Reaction Curves

Theorem 2
For every scenario j the aggregate reaction curve Qj (x) :
i) is continuous function of x
ii) verifies the following inequalities:
0

1 Qj (x) < 0, ifQj (x) > 0

0
Qj (x) = 0,
ifQj (x) = 0

(8)

i.e if Leader increases his output by 1 unit the followers globally

decrease their production by no more than 1 unit
Theorem 2.1
The same applies to joint reaction curves : for x > 0:
0
qij (x) 0, i, j
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Existence of Stochastic SNC Equilibrium:

Theorem 3
i) under the above 3 assumptions there exists a SSNC equilibrium
ii) Moreover if the aggregate reaction curves Qj (x), j = 1, ..., M,
are convex, then this equilibrium is unique

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Existence of Stochastic SNC Equilibrium:

Theorem 3
i) under the above 3 assumptions there exists a SSNC equilibrium
ii) Moreover if the aggregate reaction curves Qj (x), j = 1, ..., M,
are convex, then this equilibrium is unique
proof
SP problem (4) involves a continuous function of x,
(pj (x + Qj (x)) is continuous as Qj (x) is continuous), over a
compact nonempty set [0, qu]. Thus an optimal solution x is
exist for this problem

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Existence of Stochastic SNC Equilibrium:

proof
Need to show if Qj (x), j = 1, ..., M, are Convex,Objective
function of SP problem (4) is strictly Concave on (0, ).SP
objective function:


P
g (x) = x M
j=1 j pj x + Qj (x) f0 (x)
0



0
x + Qj (x) 1 + Qj (x)


P
0
+ M

p
x
+
Q
(x)
f0 (x)
j
j=1 j j

g (x) = x

PM

j=1 j pj

(9)
(10)

Since g (x) is strictly decreasing as its sum of non increasing

function (9) and strictley decreasing function (10).

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A Solution Algorithm to SSNC Problem

It was shown that SSNC problem has a unique equilibrium solution

whenQj (x) is convex and g (x) is concave.
Based on above the basic idea of the method is to:
Approximate each function Qj (x) by a piecewise linear curve
that coincides with Qj (x) at each break point.
The SP problem is then solved on each of these intervals
where Qj (x) is replaced by its Linear Approximation.

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Mathematical Formulation

Define:
Grid points:xk ,k = {1, ..., T }and 0 x1 < x2 < ... < xT qu
Linear appx of Qj (x) on [xk , xk+1 ] : Qkj (x)
The approximation is defined as follow:
Qkj (x) = Qj (xk ) + kj (x xk ), xk x xk+1

(11)

Where
kj =

Qj (xk+1 ) Qj (xk )
xk+1 xk

(12)

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Mathematical Formulation

And SP problem becomes as follow with the solution xk (approx of

optimal leader output on [xk , xk+1 ]):
SPk :=

max

xk xxk+1

 X

M


x
j pj x + Qkj (x) f0 (x)

(13)

j=1

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Complete SSNC Algorithm

Data to be provided as follow:
1

fi (q), Convex and twice differentiable

pj (q) satisfying Assumption(2)

qu satisfying Assumption(3)

T , Number of grid points for x

, error tolerance of optimal output

Algorithm then consist of:

1
2

Compute Qj (xk ), k = 1, ..., T

For k = 1, ..., T 1:
Solve SPk over [xk , xk+1 ]:with solution xk
Compute g (xk ): let gk = g (xk )

Find the maximum of gk over k

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