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Choosing Volatility for Long-Dated Electricity Futures Swaptions

Article Quant Q&A · Author: CasusBelli
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Summary

The document asks how to select volatility for a long-dated option on an hourly electricity swap valued with shaped monthly futures and a generation schedule. The proposed setup uses the resulting volume-weighted average price as the futures input to Black-76, assumes a zero risk-free rate, and considers implied volatility from options on the underlying contracts versus historical volatility from futures prices.

The discussion identifies practical limitations rather than reaching a valuation recommendation: the relevant options are illiquid, their implied volatilities may move sharply and later reverse, and thin trading in distant futures can create spikes in historical estimates. It also asks whether a deal-level volatility could be formed by averaging squared volatilities across the component contracts. No answer, empirical comparison, or validated aggregation method is provided, so the document is best read as a framing of the modeling and data-quality problem rather than a prescribed approach.

Key ideas

  • Long-dated electricity swaption valuation requires a volatility assumption for the underlying swap exposure.
  • Implied volatility can be forward-looking but may be unstable when options are illiquid.
  • Historical volatility can be steadier yet distorted by sparse trading in distant futures.
  • The document raises, but does not resolve, how component-contract volatilities should be aggregated.

Tags

FuturesOptionsCommoditiesVolatilityDerivatives pricing
Full text
# Which volatility should I use in a long-term futures swaption?


# Which volatility should I use in a long-term futures swaption?












Consider an option expiring in 12/31/2023 on an hourly swap from 2024 through 2029 such that: a) I pay the floating price of electricity and b) receive $20 in return. Using shaped monthly futures and an hourly generation schedule, I have calculated a VWAP, which I will use as the futures price in the Black-76 formula. The trading desk always assumes the risk-free rate is zero. The time to expiry is approximately three years (when optionality ends). I'm struggling with selecting sigma.

On the one hand, the implied volatilities of the options on the respective futures in question provide a forward view of volatility, but I am hesitant because a) the options are illiquid and b) the deal is so far in the future that a jump in IV today might just collapse tomorrow and simply cause confusion. In other words, though the analysis would be forward looking, it will likely change multiple times between now and 2024.

On the other hand, while far more stable, historical volatility is backward looking -- though the liquidity of contracts beyond 2025 is highly suspect and leads to occasional spikes (which are unlikely to recur as maturities approach). I would be hesitant to use the standard deviation of log returns of the futures prices.

Long story short: would you use IV or historical volatility in this scenario -- and why? Or is there another approach that you would recommend? Also, if implied volatility, would the IV of the deal simply be the square root of the average squared IV (the variance if we assume IV = sigma) of the 2024-2029 contracts?

Thank you for your time and kind assistance! :)

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.