Pricing Energy Contracts under Regime Switching Time-Changed models

TL;DR

This paper introduces a regime switching time-changed Levy process model for energy contract pricing, addressing limitations of the Black-Scholes-Merton model by capturing jumps and regime shifts in energy markets.

Contribution

It develops a novel model combining regime switching and time-changed Levy processes, with new pricing methods and parameter estimation techniques using energy data.

Findings

Model captures jumps and regime shifts effectively.

Pricing methods based on characteristic function expansions.

Parameter estimation aligns with historic energy data and option quotes.

Abstract

The shortcomings of the popular Black-Scholes-Merton (BSM) model have led to models which could more accurately model the behavior of the underlying assets in energy markets, particularly in electricity and future oil prices. In this paper we consider a class of regime switching time-changed Levy processes, which builds upon the BSM model by incorporating jumps through a random clock, as well as randomly varying parameters according to a two-state continuous-time Markov chain. We implement pricing methods based on expansions of the characteristic function as in \cite{Fourier}. Finally, we estimate the parameters of the model by incorporating historic energy data and option quotes using a variety of methods.