Options on Energy Portfolios in an HJM Framework

This paper implements a pricing procedure for commodity options, taking into account the stochastic nature of spot prices, currency exchange rates and convenience yields. Interest rate risk is also mentioned, but is not included in the numerical implementation. The analytic framework is heavily inspired by Miltersen&Schwartz(1998); however, while they allow the interest rate to be stochastic they do not consider exchange rate risk. Furthermore, our work differs from theirs by extending the analysis to derivatives, where the underlying energy commodity is allowed to be either a portfolio of single-delivery contracts or a flow forward. The numerical implementation is an adaptation of the stochastic duration approach in Munk(1999), and we find that this numerical method produces results quite close to the “true” prices found through Monte Carlo simulation.