A Multi-Factor Model for Energy Derivatives

Abstract

In this paper we develop a general framework for the risk management of energy derivatives. The framework is designed to be consistent not only with the market observable forward price curve but also the volatilities and correlations of forward prices. We show how these volatilities and correlations can be estimated from the market and incorporated into the model in order to price a wide range of energy derivatives. Our framework extends and synthesises the results of Amin and Jarrow [1991a,b], Cortazar and Schwartz [1994], Amin, Ng and Pirrong [1995], Schwartz [1997], and Hilliard and Reis [1998]. We demonstrate the application of our framework to oil and gas futures data from the New York Mercantile Exchange and give numerical results for the pricing of European Caps and Swaptions. A Multi-Factor Model for Energy Derivatives Clewlow and Strickland multi_factor_energy_derivatives.doc 3