Swing option valuation on electricity and natural gas markets

Swing options had been part of natural gas market before its embedded option feature was appreciated. The flexibility of delivery is valuable because of characteristic features of energy commodities as non-storability, high frequency of events and seasonality. Swing options enable this flexibility. Holder of the option is allowed to react to market situation in flexible way and change the amount of delivery up or down in some known intervals. Total deviation from negotiated amount can't exceed some boundaries in case of "take-or-pay" condition. It is not unique general valuation form of such flexible contracts as swing options. General definition of Longstaff Schwartz Least Square approximation method (LSM) is provided at first. Then it is shown other standard valuation concept as finite difference method. It is also mentioned tree method and more complex dynamic stochastic programming method. Analysis of energy commodities time series of central Europe is done and it is shown example of LSM approach use in valuing swing option with underlying asset of base load electricity in Czech Republic