Pricing options on forwards in energy markets: the role of mean reversion's speed

TL;DR

This paper examines how slow mean reversion in energy market spot prices affects the accuracy of pricing and hedging options, providing bounds for errors caused by neglecting these slow rates.

Contribution

It introduces bounds for pricing errors due to slow mean reversion in multi-factor models, highlighting the importance of mean reversion speed in energy option valuation.

Findings

Bounds for pricing errors when ignoring slow mean reversion

Slow mean reversion significantly impacts hedging accuracy

Quantitative assessment of mean reversion effects in energy markets

Abstract

Consider the problem of pricing options on forwards in energy markets, when spot prices follow a geometric multi-factor model in which several rates of mean reversion appear. In this paper we investigate the role played by slow mean reversion when pricing and hedging options. In particular, we determine both upper and lower bounds for the error one makes neglecting low rates of mean reversion in the spot price dynamics.