Pricing energy quanto options in the framework of Markov-modulated additive processes

Abstract

Abstract Energy quanto options are risk management tools that have a payoff similar to the product of the payoffs of two options, each written on an energy-related underlying. These options, as opposed to standardized contracts that only account for price risk, are designed to manage both volumetric and price risk in energy markets. Since the use of such options enables actors in the energy market also to hedge against production volume risk, they are becoming very popular. This paper considers the valuation of such an option on futures when the underlying futures prices are governed by Markov-modulated additive processes, which have independent but non-stationary increments within each regime. We derive a valuation formula by using the Fast Fourier Transform (FFT) technique under the assumption that the joint characteristic function of the log-futures prices is known analytically. We study this approximation under different regime-switching models. Several numerical case studies illustrate that our FFT-based valuation has a high precision and is much faster than Monte Carlo estimates.