Quantitative Finance, Vol. 10, No.

9, November 2010, 975–994

Pricing swing options in the electricity markets under

regime-switching uncertainty
M. I. M. WAHABy, Z. YINz and N. C. P. EDIRISINGHE*x
yDepartment of Mechanical and Industrial Engineering, Ryerson University,
Toronto, Ontario, M5B 2K3, Canada
zDepartment of Mechanical and Industrial Engineering, University of Toronto, Toronto, Ontario,
M5S 3G8, Canada
xDepartment of Statistics, Operations, and Management Science, University of Tennessee,
Knoxville, TN 37996, USA

(Received 8 August 2007; in final form 2 August 2009)

The spot price market for electricity is highly volatile. The time series of the daily average
electricity price is characterised by seasonality, mean reversion, jumps, and regime-switching
processes. In electricity markets, ‘swing’ contracts, which can provide some protection against
the day-to-day price fluctuations, are used to incorporate flexibility in acquiring given
quantities of electricity. We develop a lattice approach for the valuation of swing options by
modelling the daily average price of electricity by a regime-switching process that utilises three
regimes, consisting of Brownian motions and a mean-reverting process. Various numerical
examples are presented to illustrate the methodology.

Keywords: Swing option; Regime-switching process; Mean-reverting process;

Electricity market

1. Introduction (2008). In addition to the effect of non-storability, sharp

spikes in electricity spot prices are also due to causes such
Electricity markets portray huge risks to purchasers due to as severe weather conditions, generation outages, and
highly volatile electricity prices. For example, daily elec- transmission failures. However, these spikes are normally
tricity price volatility may reach 29%, whereas the vola- short-lived and prices generally fall back to their normal
tility of annual international stock price indices of can be levels as soon as the above causal conditions disappear.
around 20% (Huisman and Mahieu 2003). Price behaviour Given the afore-mentioned complexities, adequate models
in spot electricity markets is a very unique and complex of electricity price dynamics are required in order to
process, and it is characterised by excess volatility, and capture the main characteristics of spot electricity prices. A
occasional price spikes. This makes econometric modelling variety of models have been proposed in the literature for
of electricity price processes quite challenging. The this purpose; however, regime-switching models have
non-storability aspect, namely the fact that electricity recently earned much greater attention since they have
cannot be stored but must be consumed as soon as it is outperformed other competing models (Mount et al. 2006,
produced, makes the electricity price markets behave Bierbrauer et al. 2007, Higgs and Worthington 2008,

Kanamura and Ohashi 2008).
differently from other commodity markets. Furthermore,
peaks in electricity demand and the shape of the supply In this paper, we focus on pricing various swing options
function, which is essentially steeply increasing and based on a regime-switching model, using the data
discontinuous, add to the complexity of modelling spot obtained from Nordic Power Exchange, and employing
prices. Electricity spot prices exhibit strong seasonality on a lattice-based method. A swing option guarantees the
the annual, weekly and daily level, strong mean-reversion, option holder the right to change (or ‘swing’) the volume
and frequent extreme price spikes Higgs and Worthington of periodic deliveries of a particular commodity on certain
dates in the future, within a given delivery period, at the
prescribed strike price (Pilipovic and Wengler 1998).
*Corresponding author. Email: chanaka@utk.edu Swing options are used in markets where the physical
Quantitative Finance
ISSN 1469–7688 print/ISSN 1469–7696 online ß 2010 Taylor & Francis
http://www.informaworld.com
DOI: 10.1080/14697680903547899
976 M. I. M. Wahab et al.
transfer of the underlying commodity takes place through
interconnected networks, and such transfer is often
subject to volume restrictions, as occurs in the cases of
electricity, natural gas, and cable-based telecommunica-
tions, for instance. Swing options allow for flexible
delivery in terms of both the timing and the volume of
commodity acquired, and provide protection against
day-to-day price fluctuations from the beginning of the
option until its expiration. In other words, a swing option
permits the option holder repeatedly to exercise the right
to receive variable amounts of the commodity periodically
at certain prices. The swing option also can be viewed as a
generalization of the Bermudan option (Jaillet et al.
2004). Some important features and more general aspects
of swing options are discussed in Barbieri and Garman
(1996) and Garman and Barbieri (1997). Thompson
(1995) proposes a lattice-based contingent claim to
value a special case of swing contracts. Jaillet et al.
(2004) propose a framework to value swing options based
on a one-factor mean-reverting stochastic process for
natural gas prices with seasonal effects.
For the spot prices in the Pennsylvania–New Jersey–
Maryland (PJM) electricity market, Mount et al. (2006)
and Kanamura and Ohashi  (2008) present two- and
three-regime regime-switching models, respectively.
Similarly, for the Australian wholesale electricity
market, Higgs and Worthington (2008) introduce a
three-regime regime-switching model. In this study we
will focus on the regime-switching model for the Nordic
Power electricity market.
Researchers have modelled the dynamics of daily
electricity prices in the Nordic Power Exchange using
various characteristics such as seasonality, mean rever-
sion, jumps, and regime-switching processes. In Lucia and
Schwartz (2002), two models are proposed to describe the
stochastic process governing the spot price in the Nordic
Power Exchange. The first model is a one-factor model
with two components: a known deterministic function of
time, and a stochastic process that is either a
mean-reverting process or an Ornstein–Uhlenbeck pro-
cess. The second model is a two-factor model with three
components: a known deterministic function of time, a
mean-reverting process, and a Brownian motion.
Similarly, in Huisman and Mahieu (2003), the spot price
in the Nordic Power Exchange is modelled using a
deterministic component, which is a function of time,
and a stochastic component. The stochastic component
can be modelled by a basic random walk model, a
mean-reverting model, a mean-reverting model with sto-
chastic jumps, or a three-regime regime-switching model
that consists of a base regime, a jump regime, and a
reversing-jump regime. The base and reversing jump
regimes are specified by mean-reverting processes and
the jump regime is specified by a Brownian motion.
Huisman and Mahieu (2003) find that the spot price
dynamics is better-captured when the stochastic compo-
nent is modelled by a three-regime regime-switching
process than when using other models. However,
Bierbrauer et al. (2004) argue that in a three-regime
regime-switching model, it is not necessary to specify the
reversing-jump regime by a mean-reverting process,
instead it can be specified by a Brownian motion, because
a reversal jump, on average, is opposite to the initial jump.
The focus of this paper is to develop a lattice model to
price a swing contract by incorporating the price
dynamics described by the above stochastic processes of
the spot price of electricity. We utilise a three-regime
regime-switching model (see Bierbrauer et al. 2004). The
model is illustrated with data from the Nordic Power
Exchange. However, the proposed methodology can be
used for any regime-switching model that consists of
mean-reverting processes and Brownian motion by simply
modifying the number of regimes and types of process
that govern the regimes.
The paper is organised as follows. Section 2 discusses a
regime-switching model with three regimes. Section 3
presents a lattice approach to model the three-regime
regime-switching process. Section 4 describes a swing
option model. Section 5 presents the regime-switching
swing option valuation methodology. Section 6 illustrates
the methodologies presented in previous sections using
numerical examples. The paper is concluded in Section 7.
2. Regime-switching stochastic model
As stated earlier, Huisman and Mahieu (2003) and
Bierbrauer et al. (2004) propose a three-regime
regime-switching model to describe the stochastic com-
ponent of the spot price in the Nordic Power Exchange. It
is assumed that on each day the electricity price can be in
one of three regimes: a normal regime, a jump regime or a
reversing regime. A base regime (regime 0) is one in which
prices follow ‘normal’ electricity price dynamics. A jump
regime (regime 1) is where the price of electricity increases
or decreases dramatically signifying the presence of a
spike. A reversing regime (regime 2) is where the
electricity price reverts back to the base regime after the
spike has occurred.
The daily average system price (see figure 1) in the
Nord Pool market is denoted by Pt, and it is expressed as
the sum of a deterministic component f (t) and a stochastic
component xt as follows:
Pt ¼ f ðtÞ þ xt , ð1Þ
where f (t) is the sum of the annual cycle St and weekly cycle
st, i.e. f (t) ¼ St þ st. The annual cycle can be approximated
by the sinusoidal form St ¼ A sin[(2/365)(t þ B)] þ Ct,
where A ¼ 45.19, B ¼ 94.80 and C ¼ 0.0295 are con-
stants, see Bierbrauer et al. (2004) for details. The weekly
seasonal pattern is determined as follows: first, the weekly
trend is determined using moving average techniques, then
the seasonal component is estimated, and, finally, the
weekly seasonal cycle st is computed. See Weron (2006,
p. 44) for more details. Then, equation (1) can be
rewritten as
xt ¼ Pt  St  st , ð2Þ
 Pricing swing options in the electricity markets 977

Spot price
400

350

300

Price (NOK/MWh) 250

200

150

100

50

0
07/01/1997 01/01/1998 07/01/1998 01/01/1999 07/01/1998 01/01/2000
Days from 01/01/1997

Figure 1. Daily average system electricity price Weron et al. (2004).

and xt is called the deseasonalised average daily price.
Define yt as the logarithm of deseasonalised average daily
price, i.e.
yt ¼ logðxt Þ:
The three-regime regime-switching model for the stochas-
tic component yt of the daily price is then represented by
yt,i if yt is
Pin regime i, with probability pi (40), for i ¼ 1, 2, 3,
3 1
where i¼1 pi ¼ 1. Note that pi is time-independent
according to the regime-switching model in Bierbrauer
et al. (2004). Accordingly,
8 varying. For example, Kanamura and Ohashi 
>
> yt,1 if yt is in regime 1 with probability p1 ,
>
>
>
> where dyt,1 ¼ ð  yt,1 Þ dt þ 1 dz,
< and incorporating demand seasonality that generates
yt,2 if yt is in regime 2 with probability p2 ,
yt ¼
>
> where dyt,2 ¼ 2 dt þ 2 dz,
>
>
>
> y if yt is in regime 3 with probability p3 ,
: t,3
where dyt,3 ¼ 3 dt þ 3 dz,
where dz represents a Wiener process and i and  i are the
mean and volatility in regime i. Bierbrauer et al. (2004)
assume that on average the reversal jump is opposite to
the initial jump. Therefore, 3 ¼ 2 and  2 ¼  3. We
note that our lattice approach can be implemented
without this restrictive assumption. As noted in Section
1, several studies have modelled electricity prices using
continuous-time models, similar to that in equation (4).
However, due to the complexity of the swing options and
the regime-switching behaviour of electricity prices, the
underlying processes will be discretised using a lattice
approach in the next section.
In a three-regime regime-switching model, there are
nine transition probabilities in the Markov chain for the
evolution of the unobserved latent indicator variable,
t, and are given by
ij ¼ Prðt ¼ j j t1 ¼ iÞ for i, j ¼ 1, 2, 3,
X
3 Ritchken (1991) and Ekvall (1996) have developed lattice
where ij ¼ 1, 8i:
j¼1
Following the regime-switching model in Bierbrauer
et al. (2004), the jump regime is immediately followed by
the reversing regime, followed by the base regime. Thus,
in a 33 transition matrix, there are only four non-zero
ð3Þ probabilities:
0 1
11 1  11 0
B C
@ 0 0 1 A: ð6Þ
0 0
Several recent studies show that the transition prob-
abilities in a regime-switching model should be time-
(2007)
develop a structural model by improving supply function
ð4Þ price spikes that fit the observed data better than those
using the jump diffusion model and the Box–Cox trans-
formation model. Based on the structural model,

Kanamura and Ohashi (2008) indicate that, in
regime-switching models, transition probabilities of elec-
tricity prices cannot be constant and they must be
time-dependent. Mount et al. (2006) present a two-regime
regime-switching model with time-varying transition
probabilities. Since the lattice model employed in this
paper is flexible enough to include time-dependent
parameters, our proposed methodology can be used to
value swing options under time-varying transition prob-
abilities in the regime-switching model.
3. Lattice construction
Lattice approaches have been widely used because of their
computational simplicity and flexibility. Cox et al. (1979)
construct a binomial lattice for pricing options represent-
ing a single variable that follows a geometric Brownian
motion. Boyle (1988), Boyle et al. (1989), Kamrad and
ð5Þ approaches to represent several stochastic processes.
Also, see Edirisinghe et al. (1993) for the use of binomial
978 M. I. M. Wahab et al.

lattices in pricing options under transactions costs. Hull The regime with step size i is modelled by a binomial
and White (1990) model linear mean reversion processes lattice, which can also be considered as a trinomial lattice
in a lattice. However, these lattice approaches assume a where the conditional branch probability associated with
single regime for the underlying stochastic variables. the ‘middle’ branch is zero. Regimes with step size
Bollen (1998) proposes a pentanomial lattice approach to j ( j 6¼ i) are constructed by a trinomial lattice. The
value options when an underlying variable follows a conditional branch probabilities for all the branches
regime-switching behaviour with two regimes, in which emanating from a node can be computed by matching
each regime is described by a geometric Brownian motion. the first and second moments of the lattice with that of
In the pentanomial lattice, each regime is represented by a the continuous processes of the underlying variable. For
trinomial lattice with one branch (or outcome) being each regime, the conditional branch probabilities of the
shared by both regimes. In order to minimise the number trinomial lattice are given below. For mean-reverting
of nodes in the lattice, nodes from both regimes process:
are merged by setting the step sizes of both regimes into 8 " # " #
a 1 : 2 ratio. >
> 2
2
> j ðy
> 12  2 þ j i t,1 Þh
if 0  12  2 þ
j ðy t,1 Þh
 1,
We propose a lattice approach to value options when >
>

j ii
>
< j ii i j ii
an underlying variable follows a regime-switching process " #
p j , u ¼ 2j
with three regimes, in which regimes are described by both >
> 0, 1
if 2  2 þ ðyt,1 Þh
5 0,
>
>
j ii
a mean-reverting process and a geometric Brownian >
> j ii
>
:
motion. Our lattice approach is flexible enough in that 1, otherwise:
it can be applied under any regime-switching model that ð10Þ
consists of mean-reverting processes and Brownian
motion. Although the focus in this paper is on the Nord 8 " # " #
>
> 2j 2j
Pool market, as in Huisman and Mahieu (2003) or >  2 
> 1 ðy t,1 Þh 1
if 0  2  2  ðy t,1 Þh
 1,
>
> 2

j ii

j ii
Bierbrauer et al. (2004), the methodology can be applied >
< j ii j ii
" #
in other electricity markets as studied recently by Mount p j , d ¼ 2

et al. (2006) or Kanamura and Ohashi  (2008). > 0,

> if 12  j 2  ðy t,1 Þh
5 0,
>
>
j ii
>
> j ii
In this lattice approach, each regime is represented by a >
:
trinomial lattice where the ‘middle’ branch is shared by all 1, otherwise:
regimes. In order to reduce the number of nodes in the ð11Þ
lattice, the nodes are merged by adjusting the step sizes of
(
the three regimes into 1 : 2 : 3 ratio. The step size of regime 0, if i ¼ j,
1 (mean-reverting process) is defined as p j , m ¼ ð12Þ
1  p j , u  p j , d , if i 6¼ j:
pffiffiffi
^1 ¼ 1 h, ð7Þ
For Brownian motions:
where h represents the time interval between two layers of " #
1 2j j h
the lattice – see Nelson and Ramaswary (1990) for a p j , u ¼ þ , ð13Þ
binomial lattice construction for a mean-reverting pro- 2  j i 2 j ii
i
cess. Step sizes of regimes 2 and 3 (Brownian motions) are
" #
defined, similar to that in Bollen (1998), by 1 2j j h
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi p j , d ¼  , ð14Þ
2 ð j ii Þ2 j ii
^i ¼ i2 h þ 2i h2 , i ¼ 2, 3: ð8Þ

Note that the interval size h can be chosen sufficiently p j , m ¼ 1  p j , u  p j , d , ð15Þ

small to make all conditional branch probabilities posi-
tive. More details of the standard binomial lattice
construction can be found in Cox et al. (1979) and Hull
(2002), for instance.
Let the step sizes of regimes 1, 2 and 3, respectively, be
given by ^1 , ^2 , ^3 , see equations (7) and (8). Define the
indices k1 :¼ arg minf ^i : i ¼ 1, 2, 3g, k3 :¼ arg maxf ^i :
i ¼ 1, 2, 3g and k2 :¼ {1, 2, 3} n {k1, k3}, and set i ¼ ^ki
for i ¼ 1, 2, 3. Thus, 1  2  3 holds, and we define
¼ max{ 1, 2/2, 3/3}. If i ¼ iþ1, then we set i/
i ¼ iþ1/i. Let ¼ i/i (i.e. i/i4 j/j, 8j ), then the step
size of j should be adjusted as follows:
(
i , if j ¼ i,
j ¼ i ð9Þ
j , if j 6¼ i:
i computed using equations (7)–(15). Then, the lattice is
where  j,u,  j,m and  j,d are the conditional probabilities
for the upward, middle and downward branches of the
trinomial lattice, respectively. Notice that when j ¼ i,
which implies a binomial lattice, equations (10) and (11)
are similar to those in Nelson and Ramaswary (1990) for
a binomial lattice. Note that the probability relating to
the middle branch is equal to zero (see equation 15), that
is, as indicated earlier, one of the three regimes is
modelled using a binomial lattice.
In order to initialize the lattice, for a given day (root
node) the average spot price and deterministic compo-
nents are known. Thus, using equation (2), the value of
the stochastic component is determined. Then, step sizes
of each regime and conditional branch probabilities are
 Pricing swing options in the electricity markets
constructed for a particular period of time. Finally, at
each node, using equations (1)–(4), appropriate inverse
transformations are applied to find the average spot price.
4. Swing options
A swing option is a contract guaranteeing the option
holder the right to change (or ‘swing’) the volume of
periodic deliveries of a certain commodity on certain
dates in the future, within a given delivery period, and at
the strike price. More general definitions, mathematical
representations, and properties of swing options are
presented in Jaillet et al. (2004). Swing options may be
characterised based on the duration of the effect
associated with a right. If the exercise of a right modifies
the delivery volume only on the date of exercise, then it is
called a local effect. Whereas, if the exercise of a right
modifies the delivery volume on the exercise date and
onward, then it is called a global effect. In this paper, we
only consider local-effect swing options.
In the remainder of this section, we focus on the swing
option model that provides a customer a right to buy
variable amounts of electricity on a particular day of a
given period. In order to price the swing option, the
following must be specified: exercise dates, the amount of
electricity that the customer can purchase at each right,
the penalty function, and the exercise price.
To define the exercise dates, consider three dates
T0  T15T2. The swing option is priced on day T0. The
option holder has Y(N) rights to buy variable amount
of electricity within the period [T1, T2], where an exercise
can only occur at a discrete set of N days such that
{t1, t2, . . . , tN}  [T1, T2]. When a right is exercised on a
given date, there is a refraction time, Dt, that limits the
time interval in which a right can be exercised in
the future. The refraction time needs to be included
in the contract if Dt4min1kN1(tkþ1  tk).
An option holder can buy, sell, or buy and sell the
electricity. In this paper, we focus on modelling contracts
that can only be used to buy electricity. However, the
framework can be easily extended to accommodate
options to sell or options to buy and sell. On day tk,
1  k  N, a right allows the customer to choose a positive
incremental amount. The amount of electricity that can
be acquired is within a particular range ½Llk , Luk  due to
constraints in the transmission grid, where Luk  Llk  0.
A penalty could be imposed if the total amount of
electricity acquired by the option holder via swing rights
is not within prespecified bounds at the expiry of the
contract. One may specify a fixed penalty, or a per-unit
penalty; and also the penalty can be predetermined at the
initialization of the contract, or it can be determined at
the expiration date according to the average spot price
over the particular period.
The exercise price or strike price is the price at which a
MWh of electricity will be purchased at the time of
exercising a right. One may specify a fixed strike price
when entering the contract that remains constant
throughout the effective period of the contract.
979
Alternatively, the strike price may be linked to the value
of some reference price such as the spot price, which thus
may vary over the time of the contract.
5. Option valuation
In this section, first we briefly overview the standard
procedure to value an option using a simple binomial
lattice. Then, we explain the option valuation procedure
for an underlying variable with three regimes using the
model in Section 3. Finally, we present the option
valuation procedure for a regime-switching swing option.
5.1. Regime-switching option valuation
When real-world data is used to value financial and real
options, one must take into account the risk premium
observable in the market since options are valued in a
risk-neutral world, where the actual growth rate is
replaced with a risk-neutral equivalent drift.
Subsequently, the cash flows are discounted at the
risk-free interest rate. Therefore, an important issue is
to determine the risk-neutral equivalent drift that reflects
the risk of the option. The risk-neutral equivalent drift is
obtained by subtracting the risk premium from the actual
growth rate. The amount of the risk premium depends on
the market price of risk. Therefore, if one knows the
market price of risk, the risk-neutral equivalent drift can
be computed.
Electricity has very limited storability and transport-
ability. These two characteristics make the electricity
market different from the financial markets and other
commodity markets. As a result, determining the market
price of risk in the electricity market is not easy (see Lucia
and Schwartz 2002, Vehviläinen 2002). Several methods
to determine the risk premium are addressed in Weron
(2008). One method, which uses the convenience yield
argument, fails in our case due to non-storability of
electricity. A second method that models the forward
price dynamics instead of the spot prices is questionable
due to both the non-storability issue and violation of the
classical spot-forward price relationship. Risk premium is
the difference between forecasted spot price and forward
price, where forecasted spot price is the expected price
based on a ‘real-world’ probability measure and the
forward price is the expected price based on a
‘risk-neutral’ probability measure. Hence, calibrating
spot and forward prices infers the market price of risk
in the Nord Pool electricity market (Weron 2008). We will
follow Weron (2008) to compute the market price of risk
in the numerical examples.
To review the standard option valuation procedure in a
lattice, consider a binomial lattice that represents an
underlying variable with one regime. For a European call
option, the payoff at any terminal node (at expiry) is
calculated as the maximum of zero and the proceeds of
the option’s exercise. The option value in earlier periods is
computed as the maximum of zero and discounted
expected value of the option. In order to calculate the
980 M. I. M. Wahab et al.
expected value at each node, branch probabilities are
used. This backward recursive procedure is continued
from all terminal nodes to the initial node. For an
American option, the value at each node – except the
terminal nodes – is the maximum of exercising the option
at that particular node and the discounted expected value
of the option.
In the regime-switching model, unlike in the binomial
lattice, time-varying regime probabilities and the possi-
bility of switching among regimes at each node cause
difficulties in computing nodal expected values. It can be
overcome by computing conditional option values at each
node for each regime, where the conditioning information
is the regime that governs the prior observation. These
conditional option values are computed using a rollback
procedure from the terminal nodes to the root node.
Therefore, when there are three regimes for the underlying
variable, at each node we need to compute three condi-
tional option values, one for each regime. Moreover, the
regime-switching lattice must match the moments implied
by each regime’s distribution and should also reflect the
regime uncertainty and switching possibilities of a
regime-switching model. As the computations roll back,
the conditional option values depend on transition
probabilities because in a conditional setting the transi-
tion probabilities are equivalent to future regime
probabilities.
To illustrate the procedure, we introduce the expression
to value an American call option for an underlying
random return variable with three regimes. For an
American option, early exercise proceeds are compared
to the discounted expected value of a future exercise. An
American call option value at time t, conditional on
regime i, is
( !)
X
3
cðt, iÞ ¼ max
t  Kt , erf h
ij E½cðt þ 1, j Þ ,
j¼1
i ¼ 1, 2, 3, ð16Þ
where Kt is the exercise price at time t,  ij is the transition
probability from regimes i to j, rf is the risk-free interest
rate, and
t is the value of the underlying variable at time t. standard way iterating backward from the terminal
Notice that the call option value at time t, conditional on
regime i, is related to the conditional option values at time
t þ 1. The expectation of future conditional option
values are computed based on the conditional branch
probabilities of the appropriate set of branches.
The continuous price process of the underlying variable
can be discretised to obtain a lattice representation. If the
effective period of the swing contract is T years, then a
lattice is constructed with some integer number N of time
steps, so that h, which is the time interval between two
layers, equals T/N. Then the mean andpthe ffiffiffi volatility of the
process for duration h are h and  h, respectively. In
order accurately to discretise a continuous process, the
time increment h of the lattice should be reduced. In the
regime-switching model, not only the continuous process
but also the transition probabilities must be scaled to the
reduced time increment, since transition probabilities
between successive observations depend on the time
increment.
If the regime transition probabilities are given for a
time increment, then the transition probabilities must be
scaled appropriately whenever the increment changes.
There are two ways to adjust the transition probabilities.
Suppose that the generator matrix G of the Markov chain
is known, i.e. exp(Gh) ¼ P(h), where P(h) is the transi-
tion probability matrix for the length of the time step h.
Since
X
1 n n
h G
PðhÞ ¼ I þ ,
n!
n¼1
we have P(h) ¼ I þ Gh for a sufficiently small time step h.
Alternatively, when the Markov transition probability
matrix P(h) for a given time step h is known, then the
transition probability matrix for the new length of time
ˆ
step hˆ can be determined as P(hˆ) ¼ [P(h)]h/h. In the
regime-switching model, the transition probability
matrix is irreducible, and an irreducible matrix always
has positive eigenvalues, and thus P(hˆ) exists.
5.2. Regime-switching swing option valuation
Swing options are complicated because of multiple
exercise rights and other constraints as described in
Section 4. This complexity, along with the regime-
switching daily price of electricity, requires the modifica-
tion of the option valuation procedure presented in
Section 5.1. This modification will incorporate two
additional state variables that are necessary to price a
swing: the number of rights available and the
usage level at each right. With appropriate discretisation
of the usage level, swing options can be priced
using a multi-layered lattice (see figure 3). Jaillet et al.
(2004) show that Y2M/2 lattices are necessary to price a
swing with Y rights and M different usage levels at
each right.
Regime-switching swing options are valued in the
nodes in three dimensions: price, number of swing
rights, and usage level. As discussed in Section 5.1, for a
regime-switching process with three regimes, at each node
there are three conditional option values. In the terminal
array, at each node, three conditional option values are
simply the maximum of zero and the option’s exercise
proceeds. For earlier nodes, the possibility of exercising a
swing right early is considered by taking the maximum of
exercising a swing right and not exercising a swing right.
When not exercising a swing right, the future expected
discounted value is obtained from the same lattice.
Whereas, when exercising a swing right, the future
expected discounted value is obtained from the lattice
that represents the next lower number of swing rights and
appropriate usage level (see figure 8). To illustrate the
procedure, we introduce the expression for the swing
option value at time t conditional on regime i, with the
 Pricing swing options in the electricity markets 981

Deseasonalised spot price

6
5.8
5.6
5.4

log (price)
5.2
5
4.8
4.6
4.4
4.2
4
07/01/1997 01/01/1998 07/01/1998 01/01/1999 07/01/1999 01/01/2000
Days from 01/01/1997

Figure 2. Logarithm of deseasonalised average daily price Weron et al. (2004).5AQ104

yth(Y ) right, and the usage level lk , where k 2 M: Table 1. Estimated parameters for logarithm of deseasonalised
average daily price.
cðt, i, y, lk Þ
( ! Parameter Regime 1 Regime 2 Regime 3
X
3
¼ max lk ðPt  K~ t Þ þ erf h ij E½cðt þ 1, j, y  1, lm Þ ,  4.8731 – –
m
j¼1  0.0478 – –
!)
X
3 i – 0.0839 0.0839
erf h ij E½cðt þ 1, j, y, lk Þ , i ¼ 1, 2, 3, ð17Þ i2 0.0024 0.0697 0.0697
j¼1 pi 0.9851 0.0075 0.0075
 ii 0.9924 – –
where K~ t is the exercise price of one MWh of electricity at
time t, Pt is the price of one MWh of electricity at time t,
 ij is the transition probability from regimes i to j, and exercise price is fixed, whereas in the second example the
rf is the risk-free interest rate. exercise price is variable. In the last two examples, which
The rollback computation thus yields three conditional are the same except for the exercise price, the option
option values, one conditional option valuePfor each holder has rights to buy a variable amount of electricity at
regime, at the root node of the lattice with Y(¼ y) swing each specified day. The third example is with fixed
rights available. If one knows the current regime, then the exercise price, while the fourth example is with variable
option value is the same as the conditional option value of exercise price.
the current regime. If the current regime is not directly In the first example, we consider a swing option with
observable, the expectation of the option value can be four exercise dates and the swing rights can be exercised
computed using the probability distribution for the for three days at most. The option is priced on
regimes. 4 November 1999, and it expires on 7 November 1999.
On 4 November 1999, the risk-neutral equivalent drift of
the electricity price is computed considering the market
6. Numerical examples price of risk, , as discussed in Section 5.1. Therefore, in
equation (4),  is replaced by    1/, 2 is replaced by
In this section, in order to present numerical examples 2   2, and 3 is replaced by 3   3. The interest rate
using the proposed lattice approach for the is set at 5% per year.
regime-switching model presented in Section 2, we use With a view to computing the value of , Weron (2008)
the estimated parameters for the model in Bierbrauer et al. states that
(2004). The daily average system price and logarithm of
deseasonalised average daily price from 1 January 1997 to ‘. . . the fit to the implied market price of risk for the
25 April 2000 are presented in figures 1 and 2, respectively. first 31 trading days (i.e. until 10 December 1999),
The daily average system prices are given in NOK MWh1. y1 ¼ 0.0075x þ 8.15, is remarkably similar to the
The estimated parameters for the logarithm of deseasona- one for the whole time period: y2 ¼ 0.0074x þ 7.98.
lised average daily price are given in table 1. Hence, it can be used to forecast future (after
We consider four examples. In the first two examples, December 1999) values of .’
which are the same except for the exercise price, the
option holder has rights to buy a fixed amount of Accordingly, we use the latter expression for the whole
electricity at each specified day. In the first example the time period to compute the market price of risk on
982 M. I. M. Wahab et al.
Table 2. Data obtained from Bierbrauer et al. (2004).

Date Pt yt eyt St þ st
4 Nov. 1999 122.52 4.8003 121.5469 0.9731
5 Nov. 1999 121.04 4.8053 122.1561 1.1161
6 Nov. 1999 112.33 4.7688 117.7778 5.4478
7 Nov. 1999 110.10 4.7869 119.9290 9.8290

Table 3. Deseasonalised average daily log prices in each node.

Period 1 Period 2 Period 3 Period 4

4.800 5.197 5.593 5.989
5.064 5.461 5.857
4.932 5.329 5.725
4.800 5.197 5.593
4.668 5.064 5.461
4.536 4.932 5.329
4.404 4.800 5.197
4.668 5.064
4.536 4.932
4.404 4.800
4.272 4.668
4.140 4.536
4.008 4.404
4.272
4.140
4.008
3.876
3.744
3.612

The electricity price on 4 November 1999 is 122.52

Figure 3. A four-exercise-date swing option with three rights.
4 November 1999, where x ¼ 1040 (i.e. the 1040th day
from 30 December 1996) yields  ¼ 0.284. In the follow-
ing, we illustrate the sensitivity of the swing option value
to the market price of risk.
It may also be noted, referring to Hull (2002, p. 485),
that ‘the market price of risk is not dependent on the
nature of the derivative and at any time the market price
of risk must be the same for all derivatives that are
dependent on the same underlying variable.’ Accordingly,
the value of implied market price of risk from a class of
options, such as Asian options, could be used to value the
swing option for the same period.
NOK MWh1. The option holder has rights to buy one
MWh of electricity at 122.52 NOK without penalty on or
before 7 November 1999, at most three days. To value
such an option, imagine three layers of lattices as in
figure 3 that shows relationships among nodes in the
lattices. A heptanomial lattice is constructed to represent
a regime-switching process with three regimes. The time
step of the lattice corresponds to a day. Figures 3(a), (b)
and (c) represent that the option holder has one right, two
rights and three rights, respectively. The valuation pro-
cedure of the swing option starts from the bottom lattice
(figure 3(a)), and then the middle lattice (figure 3(b)), and
finally the top lattice (figure 3(c)).
In order to construct the heptanomial lattice, the step
size of the first regime is computed using equation (7) and
the step sizes of the other two regimes are computed using
equation (8) and the step sizes are ^1 ¼ 0.0490,
^2 ¼ 0.2642 and ^3 ¼ 0.3081. Then the step sizes are
adjusted according to equation (9) so that the nodes are
equally spaced and merged (i.e. 0.049050.264250.3081
and ¼ max{0.0490, 0.2642/2, 0.3081/3} ¼ 0.1321).
Therefore the step size is 0.1321. From Bierbrauer et al.
(2004), the average daily prices, Pt, and deseasonalised
average daily log prices, yt, are obtained and given in the
second and the third columns of table 2, respectively.
From equation (3), xt, which is eyt, is obtained and given
in the fourth column. From equations (2) and (3), St þ st,
which is Pt  xt, is obtained and given in the fifth column.
Since yt follows a regime-switching process, we first
develop a heptanomial lattice for it as given in table 3.
 Pricing swing options in the electricity markets 983

Figure 4. Heptanomial lattice for the price movements of one MWh of electricity.

For example, the first value in layer 2 is computed as
4.800 þ 3  0.1321 ¼ 5.197 and the second value in layer 2
is computed as 4.800 þ 2  0.1321 ¼ 5.064. Then, at each
node, we compute xt values by using the inverse of
equation (3). Finally, in order to compute the average
daily prices, we add the seasonal components 0.9731,
1.1161, 5.4478, 9.8290 to period 1, period 2, period 3
and period 4, respectively. Figure 4 represents the average
daily prices movement of one MWh of electricity from
4 November 1999 to 7 November 1999. For example,
the first value in period 2 is computed as e5.197  1.1161 ¼
179.52 and the second value in period 2 is computed as
e5.064  1.1161 ¼ 157.17.
The conditional branch probabilities of regime 1 are
computed using equations (10)–(12) and given in table 4.
The conditional branch probabilities of the other two
regimes are computed using equations (13)–(15). Regime 2
has 0.5169, 0.0000 and 0.4831 conditional branch
probabilities for the upward, middle and downward
branches, respectively; regime 3 has 0.1019, 0.3953 and
984 M. I. M. Wahab et al.
Table 4. Conditional branch probabilities of regime 1. 0.5028 conditional branch probabilities for the upward,
Node Up Middle Down middle and downward branches, respectively.
The lattices in figures 3(a), (b) and (c) are shown with
1 0 0.7982 0.2018 payoffs in figures 5, 6 and 7, respectively. At each node,
2 0 0.8221 0.1779
3 0 0.8460 0.1540 the first number represents the payoff of regime 1, the
4 0.0075 0.8624 0.1301 second number represents the payoff of regime 2, and the
5 0.0314 0.8624 0.1062 third number represents the payoff of regime 3. In the last
6 0.0553 0.8624 0.0823 period, at each node, payoff values are the same for all
7 0.0792 0.8624 0.0584
8 0.1031 0.8624 0.0345
regimes. Except for the last period, at each node, the
9 0.1270 0.8624 0.0106 maximum payoff of exercising and not exercising an
10 0.1509 0.8491 0 option is calculated. Since figure 5 displays one swing
11 0.1748 0.8252 0 right and the option holder can use his/her right at any
12 0.1987 0.8013 0 day, the payoffs are computed as an American option.
13 0.2226 0.7774 0
The details of the backward-recursive numerical

Figure 5. Detailed heptanomial lattice of figure 3(a).

 Pricing swing options in the electricity markets 985

Figure 6. Detailed heptanomial lattice of figure 3(b).

computations for this example are provided in
Appendix A. The option value in this example turns out
to be 4.86 NOK.
In the second example, we consider the same swing
option as in the first example except for the exercise price.
In this example, the option holder can buy electricity
on 4 November 1999 at 122 NOK MWh1, on 5
November 1999 at 120 NOK MWh1, on 6 November
1999 at 118 NOK MWh1, and on 7 November 1999
at 116 NOK MWh1. Working backwards from the
bottom lattice to the top lattice, the payoffs at the root
node of the top lattice for regimes 1, 2 and 3 are 7.27, 18.11
and 6.98, respectively. If the initial regime probabilities are
the unconditional regimes probabilities, the value of the
swing option is 7.35 NOK.
In the third example, we consider a swing option with
four exercise dates. The option is priced on 4 November
1999 and it expires on 7 November 1999. The electricity
986 M. I. M. Wahab et al.

Figure 7. Detailed heptanomial lattice of Figure 3(c).

price on 4 November 1999 is 122.52 NOK MWh1. The
option holder has rights to buy electricity at 122.52 NOK
MWh1 for at most two days between 4 November 1999
and 7 November 1999. Each right allows the option
holder to purchase 1 or 2 MWh of electricity, but the
option holder can only buy a maximum of 3 MWh
without any penalty using the swing option. To value such
an option, consider two layers of lattices as in figure 8. In
the bottom layer, there are two heptanomial lattices.
Figure 8(c) represents the scenario when the option holder
has only one right and buys 2 MWh of electricity, and
figure 8(d) represents the scenario when the option holder
has only one right and buys 1 MWh of electricity. In the
top layer, there are two heptanomial lattices. Figure 8(b)
represents when the option holder has two rights and buys
2 MWh of electricity using a right. Figure 8(a) represents
the case when the option holder has two rights and buys
1 MWh of electricity using a right.
The lattices in figures 8(c) and (d) are shown with
payoffs in figures 9 and 5, respectively. figures 8(a)
 Pricing swing options in the electricity markets
Figure 8. A four-exercise-date swing option with two rights.
and (b) are presented with payoffs in figures 10 and 11.
Since figures 8(c) and (d) represent one swing right
and the option holder can use his/her right at any
specified day, the payoffs are computed as in
American options. The details of the backward-recursive
numerical computations for this example are provided in
Appendix B. The option value in this example turns out to
be 6.25 NOK.
In the fourth example, we consider the same swing
option as in the third example except for the exercise
price. Suppose the option holder can buy electricity on
4 November 1999 at 122 NOK MWh1, on 5 November
1999 at 120 NOK MWh1, on 6 November 1999 at 118
NOK MWh1, and on 7 November 1999 at 116 NOK
MWh1. Working backwards in the lattices presented in
figures 5, 9, 10 and 11, at the root node in figure 10 the
values of the swing option for regimes 1, 2 and 3 are 8.50,
19.06 and 8.20, respectively; at the root node in figure 11,
the values of the swing option for regimes 1, 2 and 3 are
9.33, 19.82 and 8.99, respectively. If the initial regime
probabilities are the unconditional regime probabilities,
the value of the swing option in figure 10 is 8.58 NOK; the
value of the swing option in figure 11 is 9.40 NOK. Since
the option holder has two choices to buy either 1 or 2
MWh, the swing option price is the average of those
two values. Therefore, the swing option value is
8.99 NOK.
987
6.1. Swing option sensitivity
Next, we study the sensitivity of the swing option value as
the parameters in the regime-switching model and the
input parameters are changed. We consider the first
example and vary the initial price of electricity, the
standard deviation of regime 1 (mean-reverting regime),
and the market price of risk of the electricity price. First,
the initial price of the electricity is varied from 100 to 135
NOK (in steps of 5 NOK) and the resulting behaviour of
the swing option value is depicted in figure 12. This
sensitivity is the delta of the swing option, which is the
rate of change of the swing option price on electricity
price. Second, the standard deviation of the
mean-reverting regime is varied from 0.01 to 0.1 (in
steps of 0.01), and the behaviour of the swing option
value is presented in figure 13. It is evident, as one would
expect, that when the standard deviation of a regime
increases the swing option value increases as well. Third,
the sensitivity of the swing option value to the market
price of risk (MPR) of the electricity price is investigated
by varying MPR from 0 to 0.4 (in steps of 0.05). The
resulting sensitivity in figure 14 demonstrates that the
swing option value decreases as the market price of risk
increases.
As a point of comparison, we benchmark the swing
values obtained from our regime-switching model against
988 M. I. M. Wahab et al.

Figure 9. Detailed pentanomial lattice of figure 8(c).

the option values obtained using a geometric Brownian
motion. In order meaningfully to compare the
regime-switching process and geometric Brownian
motion, we choose the parameters of the geometric
Brownian motion that reflect all three regimes of the
regime-switching process. The variance of the geometric
Brownian motion is computed as the weighted average of
the three regimes’ variances, where the unconditional
probabilities of each regime are used as weights. Thus,
denoting the variancePof the geometric Brownian motion
by  2, we have  2 ¼ i pi i2 ¼ 0.00341. The mean of the
geometric Brownian motion is determined when a swing
option value based on the geometric Brownian motion is
the same as that based on the regime-switching process.
 Pricing swing options in the electricity markets 989

Figure 10. Detailed pentanomial lattice of figure 8(a).

Consequently, computed differences in the two option
values, using the regime-switching process and geometric
Brownian motion, would highlight the differences in
characteristics of the underlying two stochastic processes.
A similar approach is employed in Bollen (1999) to
compare project values with a regime-switching process
and a geometric Brownian motion. Accordingly, the mean
of the geometric Brownian motion is set at 0.011495 as
determined using a swing option, which is the same as the
first example but with ten exercise dates and at most ten
swing rights.
Table 5 presents the option values obtained with the
regime-switching process and the geometric Brownian
motion. Note that the number of layers in the lattice is
equal to the number of rights and the number of time
steps in the lattice is equal to the number of exercise days.
990 M. I. M. Wahab et al.

For a given number of exercise days, as the number of
rights increases, there is more flexibility for the option
holder to exercise the option at several optimal points.
Hence, the option value increases. Referring to table 5,
for 20 exercise days and under the regime-switching
process, the option values are 80.74, 137.47, 172.13 and
179.70, respectively, for 5, 10, 15 and 20 rights; however,
in the case of geometric Brownian motion, the option
values are 45.49, 63.13, 70.01 and 71.85 for 5, 10, 15 and
20 rights, respectively. On the other hand, for a given
number of rights, as the number of exercise days
increases, there is also more flexibility for the option
holder to exercise the option at several optimal points.
This does increase the option value as well. This is evident
in table 5. For example, with 20 rights, the option values
steadily increase from 179.70 to 316.25 when the number
of exercise days increases from 20 to 30, under the
regime-switching process. As for the geometric Brownian

Figure 11. Detailed pentanomial lattice of Figure 8(b).

 Pricing swing options in the electricity markets 991

Variation of option value with electricity price motion, option values increase moderately from 71.85 to
74.66 when the number of exercise days is increased from
20 to 30. It can be concluded from this table that the
incremental increases in the option value obtained under
Option value

the case of geometric Brownian motion are not significant

as either the number of exercise days or the number of
rights increase. Evidently, the use of geometric Brownian
motion does not adequately capture the distinguishing
character of electricity prices, namely the presence of
mean reversion and infrequent but large spikes (Mount
et al. 2006).
Next, we focus on the computational feasibility of the
Electricity price presented methodology for computing swing option
values when the number of time periods and the
Figure 12. Swing option value with electricity price.
number of rights are relatively larger than the examples
considered so far. Consider a swing option that is the
Variation of option value with standard same as the first example but with 60 exercise days and at
deviation of regime 1 most 60 swing rights. The model is coded in MATLAB
under the Windows XP operating system on a PC with a
1.86 GHz CPU and 1 GB of memory. The option values
Option value

and the CPU times are given in table 6. Observe that the
largest case, where the swing option has 60 exercise dates
and at most 60 swing rights for a fixed amount electricity,
is solved in under 63 CPU seconds.

Standard deviation of regime 1 7. Concluding remarks

Figure 13. Swing option value with standard deviation of
regime 1. We have presented a lattice approach for the valuation of
swing contracts under a regime-switching underlying
random variable characterised by Brownian motions
Variation of option value with market price of risk and a mean-reverting process. Swing options are compli-
cated because of multiple exercise rights and other
constraints. This complexity, along with the
Option value

regime-switching uncertainty of the daily price, requires

Market price of risk
Figure 14. Swing option value with market price of risk.
efficient numerical procedures to value swing options.
The approach presented in this paper involves
multi-layered multinomial lattices that represent the
discretisation of the stochastic processes and multiple
decision variables. The proposed approach can be used to
value varied swing options in electricity markets from the
view-point of a profit-maximizing agent. The detailed

Table 5. Option values obtained from the regime-switching process and geometric Brownian motion.

Exercise days
No. of
rights 5 10 15 20 25 30

Regime-switching 5 10.43 44.19 66.96 80.74 93.64 110.74

process 10 53.36 106.18 137.47 165.19 197.94
15 114.36 172.13 217.10 266.37
20 179.70 248.80 316.25
25 255.85 347.03
30 353.99
Geometric 5 28.09 42.90 44.95 45.49 45.67 45.75
Brownian motion 10 53.36 61.49 63.13 63.64 63.83
15 65.78 70.01 71.01 71.37
20 71.85 74.07 74.66
25 74.86 76.03
30 76.39
992 M. I. M. Wahab et al.
Table 6. Option values obtained from the regime-switching process and computation time in CPU seconds.

Exercise days
No. of
rights 10 20 30 40 50 60

Option values 10 53.36 137.47 197.94 237.58 277.12 301.40

20 179.70 316.25 404.08 483.30 536.13
30 353.99 507.06 633.07 717.33
40 539.43 725.52 849.31
50 754.84 929.06
60 953.71
Computation time 10 0.59 2.02 2.77 4.61 8.53 12.59
20 3.75 6.77 10.38 17.59 22.06
30 10.30 15.11 25.52 33.45
40 20.53 32.39 41.84
50 38.08 52.88
60 62.56

numerical examples exemplify the proposed
methodology.
It is noteworthy that swing options can be considered
as path-dependent and exotic contracts. Therefore, the
Least Squares Monte Carlo simulation approach (LSM)
proposed by Longstaff and Schwartz (2001) for
path-dependent and exotic options can be extended to
value swing options. For instance, in the case of the first
example in this section, for a given number of sample
paths, the first right of the swing option can be simulated
as an American option using the LSM approach, and then
the subsequent rights of the swing option can be
simulated using the LSM approach by comparing the
value of immediate exercise of a right at a given period
with that due to waiting until the next period for exercise.
Acknowledgement
The authors wish to thank the anonymous referees for
their many valuable suggestions that significantly
improved the exposition of this paper.
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Appendix A: Computing option values in Example 1
In figure 5, in the last period at the top node, the payoff is
calculated as max{(389.20  122.52), 0} ¼ 266.68. In the
second period at the fourth node, the payoffs for regimes
1, 2 and 3 are calculated as
1:48 ¼ maxfð120:42  122:52Þ, eð0:05=365Þ
 ½0:9924  ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ þ 0:0076  ð0:5169  30:33
þ 0:0000  4:92 þ 0:4831  0:65Þg
¼ maxf2:10, 1:48g:
5:56 ¼ maxfð120:42  122:52Þ, eð0:05=365Þ  1
 ð0:1019  52:68 þ 0:3953  0:50
þ 0:5028  0:00Þg ¼ maxf2:10, 5:56g:
1:37 ¼ maxfð120:42  122:52Þ, eð0:05=365Þ  1
 ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þg ¼ maxf2:10, 1:37g:
In figure 6, the swing option holder has two rights. At
any node, if the option holder exercises a right, then the
holder is left with one right, which means that future
payoffs for the next period are considered from figure 5.
Therefore, the resulting payoff is from currently exercising
a right plus the expected discounted payoff from the next
period in figure 5. If the option holder does not exercise a
swing right, the payoffs for the next period are considered
in figure 6. Therefore, the resulting payoff is the expected
discounted payoff from next period in figure 6.
For example, in the second period at the fourth node, the
payoffs for regimes 1, 2 and 3 are calculated by
2:12 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½0:9924  ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ þ 0:0076  ð0:5169  30:33
þ 0:0000  4:92 þ 0:4831  0:65Þ,
eð0:05=365Þ  ½0:9924  ð0:0792  17:80
þ 0:8624  0:60 þ 0:0584  0:03Þ
þ 0:0076  ð0:5169  51:07 þ 0:0000
 4:92 þ 0:4831  0:65Þg
¼ maxf0:62;2:12g:
10:21 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ  1
 ð0:1019  52:68 þ 0:3953  0:50
þ 0:5028  0:00Þ,eð0:05=365Þ  1  ð0:1019  98:26
þ 0:3953  0:50 þ 0:5028  0:00Þg
¼ maxf3:46;10:21g:
993
1:93 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ  1
 ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ,eð0:05=365Þ  1  ð0:0792  17:80
þ 0:8624  0:60 þ 0:0584  0:03Þg
¼ maxf0:73, 1:93g:
In figure 7, the swing option holder has three rights. At
any node, if the option holder exercises a right, the holder
has two rights. The future payoffs for the next period are
considered in figure 6. Therefore, the resulting payoff is
from currently exercising a right plus the expected
discounted payoff from the next period in figure 6. If
the option holder does not exercise a swing right, then the
payoffs for the next period are considered in figure 7.
Therefore, the resulting payoff is the expected discounted
payoff from the next period in figure 7. For example, in
the second period at the fourth node, the payoffs for
regimes 1, 2 and 3 are calculated by
2:12 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½0:9924  ð0:0792  17:80 þ 0:8624  0:60
þ 0:0584  0:03Þ þ 0:0076  ð0:5169  51:07
þ 0:0000  4:92 þ 0:4831  0:65Þ,
eð0:05=365Þ  ½0:9924  ð0:0792  17:80 þ 0:8624
 0:60 þ 0:0584  0:03Þ
þ 0:0076  ð0:5169  51:07 þ 0:0000  4:92
þ 0:4831  0:65Þg
¼ maxf0:02, 2:12g:
10:21 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ  1
 ð0:1019  52:68 þ 0:3953  0:50
þ 0:5028  0:00Þ,eð0:05=365Þ  1  ð0:1019  98:26
þ 0:3953  0:50 þ 0:5028  0:00Þg
¼ maxf3:46, 10:21g:
1:93 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ  1
 ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ,eð0:05=365Þ  1  ð0:0792  17:80
þ 0:8624  0:60 þ 0:0584  0:03Þg
¼ maxf0:73, 1:93g:
Working backwards from the bottom lattice (figure 5) to
the top lattice (figure 7), at the root node of the top lattice
(figure 7), the values of the swing options for regimes 1, 2
and 3 are 4.78, 16.05 and 4.50, respectively. When the
current regime is known, the corresponding conditional
option value at the root node is chosen. When the regimes
are not known with certainty, the option value is a
weighted average of the three conditional option values
with weights being the initial regime probabilities. If we
consider that the initial regime probabilities are the
unconditional regime probabilities, the value of the swing
option is 4.78  0.9850 þ 16.05  0.0075 þ 4.50  0.0075 ¼
4.86 NOK.
994 M. I. M. Wahab et al.
Appendix B: Computing option values in Example 3
In figure 9, in the last period at the top node, the payoff is
calculated as max{2(389.205  122.52), 0} ¼ 533.37. In the
second period at the fourth node, the payoffs for regimes
1, 2, 3 are calculated as, respectively,
2:96 ¼ maxf2  ð120:42  122:52Þ, eð0:05=365Þ
 ½0:9924  ð0:0792  21:48 þ 0:8624  1:20
þ 0:0584  0:05Þ þ 0:0076  ð0:5169  60:66
þ 0:0000  9:84 þ 0:4831  1:30Þg
¼ maxf4:20, 2:96g:
11:13 ¼ maxf2  ð120:42  122:52Þ, eð0:05=365Þ
 ½1  ð0:1019  105:36 þ 0:3953  1:01
þ 0:5028  0:00Þg ¼ maxf4:20, 11:13g:
ð0:05=365Þ
2:74 ¼ maxf2  ð120:42  122:52Þ, e
 ½1  ð0:0792  21:48 þ 0:8624  1:20
þ 0:0584  0:05Þg ¼ maxf4:20, 2:74g:
In figures 8(a) and (b), the swing option holder has two
rights. At any node, if the holder exercises a right then the
option holder will be left with one right, which means that
future payoffs for the next period are considered in figures
8(c) or (d). The resulting payoff is obtained via currently
exercising a right plus the expected discounted payoff
from the next period in figures 8(c) or (d). There are two
cases: in case one, the option holder has two rights and
buys 1 MWh of electricity using a right. Then the option
holder can either buy 1 or 2 MWh of electricity using the
right he/she is left with, because the option holder can buy
a maximum of 3 MWh of electricity using the swing
option. Therefore, when exercising a swing right and
buying 1 MWh of electricity (figure 8(a)), the future
expected discounted payoff from the next period is linked
to both bottom lattices with 1 and 2 MWh (figures 8(c)
and (d)). In case two, the option holder has two rights and
buys 2 MWh of electricity using a right. Then the option
holder can only buy 1 MWh of electricity using the right
he/she is left with, because the option holder can only buy
a maximum of 3 MWh of electricity using the swing
option. Therefore, when exercising a swing right and
buying 2 MWh of electricity (figure 8(b)), the future
expected discounted payoff from the next period is only
linked to the bottom lattice with 1 MWh (figure 8(d)). If
the option holder does not exercise the right then the
resulting payoff is the expected discounted payoff from
the next period in the same lattice. For example, in figure
10, the payoffs for regimes 1, 2 and 3 in the second period
at the fourth node are calculated as
2:75 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½0:9924  ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ þ 0:0076  ð0:5169  30:33 þ 0:0000
 4:92 þ 0:4831  0:65Þ,
ð120:42  122:52Þ þ eð0:05=365Þ  ½0:9924  ð0:0792
 21:48 þ 0:8624  1:20 þ 0:0584  0:05Þ
þ 0:0076  ð0:5169  60:66 þ 0:0000  9:84
þ 0:4831  1:30Þ,
eð0:05=365Þ  ½0:9924  ð0:0792  24:85 þ 0:8624
 0:60 þ 0:0584  0:03Þ
þ 0:0076  ð0:5169  71:80 þ 0:0000
 4:92 þ 0:4831  0:65Þg
¼ maxf0:62; 0:86;2:75g:
14:85 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½1  ð0:1019  52:68 þ 0:3953  0:05
þ 0:5028  0:00Þ, ð120:42  122:52Þ þ eð0:05=365Þ
 ½1  ð0:1019  105:36 þ 0:3953  1:01
þ 0:5028  0:00Þ, eð0:05=365Þ  ½1  ð0:1019  143:83
þ 0:3953  0:50 þ 0:5028  0:00Þg
¼ maxf3:29, 9:03,14:85g:
2:49 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 f1  ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þg,ð120:42  122:52Þ þ eð0:05=365Þ
 ½1  ð0:0792  21:48 þ 0:8624  1:20
þ 0:0584  0:05Þ, eð0:05=365Þ  ½1  ð0:0792  24:85
þ 0:8624  0:60 þ 0:0584  0:03Þg
¼ maxf0:73, 0:64, 2:49g:
In figure 11, the payoffs for regimes 1, 2 and 3 in the
second period at the fourth node are calculated as
3:60 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½0:9924  ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ þ 0:0076  ð0:5169  30:33
þ 0:0000  4:92 þ 0:4831  0:65Þg,
eð0:05=365Þ  ½0:9924  ð0:0792  28:54 þ 0:8624  1:20
þ 0:0584  0:05Þ
þ 0:0076  ð0:5169  81:39 þ 0:0000  9:84
þ 0:4831  1:30Þg ¼ maxf0:62, 3:60g:
15:77 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½1  ð0:1019  52:68 þ 0:3953  0:05
þ 0:5028  0:00Þ, eð0:05=365Þ  ½1  ð0:1019  150:94
þ 0:3953  1:01 þ 0:5028  0:00Þg
¼ maxf3:29, 15:77g:
3:30 ¼ maxfð120:42  122:52Þ þ eð0:05=365Þ
 ½1  ð0:0792  10:74 þ 0:8624  0:60
þ 0:0584  0:02Þ, eð0:05=365Þ  ½1  ð0:0792  28:54
þ 0:8624  1:20 þ 0:0584  0:05Þg
¼ maxf0:73, 3:30g:
Working backwards in the lattices presented in figures 5, 9,
10 and 11, at the root node of figure 10 the values of the
swing option for regimes 1, 2 and 3 are 5.63, 16.97 and 5.34,
respectively; at the root node of figure (11) the values of the
swing option for regimes 1, 2 and 3 are 6.71, 18.01 and 6.39,
respectively. If the initial regime probabilities are the
unconditional regime probabilities, the value of the swing
option in figure (10) is 5.71 NOK; the value of the swing
option in figure 11 is 6.79 NOK. Since the option holder
has two choices to buy either 1 or 2 MWh, the swing option
price is the average of those two values. Therefore, the
swing option value is 6.25 NOK.
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