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! :)

  • $\begingroup$ I understand that this is a hypothetical question. Yet;Are you going to hedge the deal in the mean time? What hedges will be available? Who is the counter party; can you add a safety margin into the price? If you cannot derive a price from other market quotes, you’ll need some (good) model,no? $\endgroup$ – Kermittfrog Dec 6 '20 at 19:57
  • $\begingroup$ This deal is meant to be a hedge for me (the electricity producer) in the event that market prices dip below $20. The counterpart is an investment bank and the deal structure is fixed (I am already in the swaption and am considering exiting). The only prices available are the 2024-2029 monthly futures prices on ICE and some options prices / IV from brokers and ICE. That's all. $\endgroup$ – CasusBelli Dec 6 '20 at 20:26

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