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A colleague of mine and I are debating how to price an electricity swap. Keeping in mind that electricity futures are delivered over a period of time rather than at a point in time, I maintain that the value of a swap is simply the difference between the futures price for a given month (the floating leg) and some fixed price (the fixed leg).

He maintains, however, that this understates the value of the swap, because it doesn't account for potential upside in the price (assuming a long position in the floating leg) of the underlying, so he recommends applying Black-76 to the contract, with the price in the fixed leg as the strike.

My issues with this approach are: a) that the value of the swap at initialization is not zero (so, if this is the correct value, why would a counterpart enter the deal?), and b) the price of an option is non-negative, but we know a swap can have a negative value.

Who, if either of us, is right? And, if neither, which approach would you recommend?

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    $\begingroup$ If this a swap, the holder is exposed to upside and downside of the underlying. If the fixed leg is such that the swap PV is zero, the PV of the upside and the PV of the downside cancel out. $\endgroup$ Commented Mar 16, 2021 at 15:49
  • $\begingroup$ Thank you. This was exactly my sentiment. $\endgroup$
    – CasusBelli
    Commented Mar 16, 2021 at 17:04

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The way you're describing it with a fixed leg (ICE standard), I'd say swap. I wouldn't go to anything more sophisticated unless it's float-for-float cross-commodity (i.e. hedge for gen) or across location (i.e., hedge for transmission, i.e. FTRs). Vols will rip and cors will break down on you so fast, the added sophistication doesn't really give you anything unless you can find some way to offload the tail risk.

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