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Utility indifference pricing and hedging for structured contracts in energy markets

Author

Listed:
  • Giorgia Callegaro

    (University of Padova)

  • Luciano Campi

    (London School of Economics)

  • Valeria Giusto

    (Phinergy S.r.l.s.)

  • Tiziano Vargiolu

    (University of Padova)

Abstract

In this paper we study the pricing and hedging of structured products in energy markets, such as swing and virtual gas storage, using the exponential utility indifference pricing approach in a general incomplete multivariate market model driven by finitely many stochastic factors. The buyer of such contracts is allowed to trade in the forward market in order to hedge the risk of his position. We fully characterize the buyer’s utility indifference price of a given product in terms of continuous viscosity solutions of suitable nonlinear PDEs. This gives a way to identify reasonable candidates for the optimal exercise strategy for the structured product as well as for the corresponding hedging strategy. Moreover, in a model with two correlated assets, one traded and one nontraded, we obtain a representation of the price as the value function of an auxiliary simpler optimization problem under a risk neutral probability, that can be viewed as a perturbation of the minimal entropy martingale measure. Finally, numerical results are provided.

Suggested Citation

  • Giorgia Callegaro & Luciano Campi & Valeria Giusto & Tiziano Vargiolu, 2017. "Utility indifference pricing and hedging for structured contracts in energy markets," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 85(2), pages 265-303, April.
    • Handle: RePEc:spr:mathme:v:85:y:2017:i:2:d:10.1007_s00186-016-0569-6
    DOI: 10.1007/s00186-016-0569-6
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    Cited by:

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    3. Picarelli, Athena & Vargiolu, Tiziano, 2021. "Optimal management of pumped hydroelectric production with state constrained optimal control," Journal of Economic Dynamics and Control, Elsevier, vol. 126(C).

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    More about this item

    Keywords

    Swing contract; Virtual storage contract; Utility indifference pricing; HJB equations; Viscosity solutions; Minimal entropy martingale measure;
    All these keywords.

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General

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