Pricing Electricity Swaptions Under a Stochastic Volatility Term-Structure Model

This paper suggests a stochastic volatility term-structure model applied to the pricing of electricity swaptions in the Nordic power market traded at the Nasdaq OMX Commodities exchange. The volatility structure in the model is specified as a product of a time-dependent function that handles the maturity effect, and a Cox-Ingersoll-Ross process for the stochastic volatility. We employ a Fourier based approach to price electricity swaptions and perform an empirical analysis by calibrating the model to a data set consisting of more than 12000 pairs of implied bid-ask volatilities corresponding to swaption prices from the Nordic power market. We show that our model outperforms the log-normal benchmark both in-sample and out-of-sample