Pricing of Swing Options in a Mean Reverting Model with Jumps

Abstract

We investigate the pricing of swing options in a model where the logarithm of the spot price is the sum of a deterministic seasonal trend and an Ornstein–Uhlenbeck process driven by a jump diffusion. First we calibrate the model to Nord Pool electricity market data. Second, the existence of an optimal exercise strategy is proved, and we present a numerical algorithm for computation of the swing option prices. It involves dynamic programming and the solution of multiple parabolic partial integro‐differential equations by finite differences. Numerical results show that adding jumps to a diffusion may result in 2–35% higher swing option prices, depending on the moneyness and timing flexibility of the option.