HEDGING SWING OPTIONS

We study models for electricity pricing and derivatives in the context of a deregulated market setting. In particular we value swing options, since these are the electricity derivatives that attract the most attention from market participants. These are American style options in that they allow for multiple exercises subject to a set of constraints on the consumption process. Through the use of a penalty function, we generalize the problem by allowing for the consumption restrictions to be broken. We characterize the price function as a stochastic optimal control problem, and show that the option is exercised in a bang-bang fashion. The value of the swing option is the solution to a backward stochastic differential equation, and we show how European calls, along with forward contracts, can be used to hedge them.