From a hedging perspective, which is the better option, the Vanilla or the Asian option?
The options give you the right to buy or sell power or gas at a given price. This can be used to create a cap on future gas prices by buying a call option, which could be interesting for an energy consumer or reseller (or a floor via put options for a producer). You choose the option before the future contract to have the choice of lower prices if the market falls.
With the standard vanilla (European or American) option you have the choice to exercise the option at maturity, which usually is close to the start of the delivery period under the futures contract. When exercised, your call option will deliver a futures contract, which give you the fixed agreed price as protection for higher prices. If he market has fallen below the agreed price (strike price) you would decline to exercise the option and buy the future contract cheaper in the market instead. However, this choice it is not always that simple.
In the power and gas markets futures are covering a time period, not a single point in time.
Trading jargon uses delivery period as the definition for the time period stipulated by the futures contract.
The future contracts are settled against the average spot price during the delivery period.
The markets pricing of the future is thus the markets belief of the average spot price during the futures contracts “delivery period”.
In a situation where your options are at the money at expiry and the market is very volatile and is expected continue to be so during the delivery period, it may be hard to make the decision whether to exercise or not. The market may fall after you choose to exercise the option and you may end up having locked in higher prices with an expensive futures contract relative the actual spot prices on average during in the delivery period. If this would happen after you exercised the option, the future that looked like the better choice in the first place ended up to be the worse choice.
A good alternative to the European or American option is the Asian option. The name implies that the option has some averaging features. More importantly it has a look back function and the options is exercised after the delivery period is over, at the point in time when the actual delivery price is known. The exercise functions like a settlement for a future but the payout is only positive for the buyer. The settlement for an Asian call option for a delivery month is calculated by taking the average of all the spot prices through out the month and compares that to the strike level when the month has passed. For a financially settled option, the option pays out the difference between the market price and the strike level only if is to the benefit of the buyer of the option. For a physically settled option, The buyer of a call pays the lower price of the strike price and the average spot during the month. The procedure removes the speculation or uncertainty whether or not the option should be exercised.
The vanilla option cost less than the Asian option as it has shorter term. It is also cheaper for the seller to hedge with theoretical lower volatility (the main price driver). Think of it as if you would buy a vanilla call for a future on a calendar year which starts within a month and compare that to buying an Asian for the same delivery period. The first option would have tops 30 days of time value and the second some 395 days. Hedging the first one is done by delta hedging with the calendar year. The latter has to be delta hedge by rebalanced with many different futures throughout the remaining time span as the calendar year seize to trade trading and the hedger needs to use daily, weekly, monthly and quarterly futures, all with higher volatility than the calendar year.
So which one is the better? The answer is found when assessing risk preference and competitive situation relative to the willingness to pay for security. The asian option cost more in premium but provides an upside throughout the delivery period. The vanilla option becomes a fixed price instrument during the delivery period so the question a company must ask it self is what kind of situation does it want to have during the delivery period. For vanilla options deep in the money this is not an issue but managing a fixed price that becomes out of the money over a longer period must be managed through the business model.
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