Swing Options

Swing options are the main type of volumetric contracts in commodity markets. A swing contract gives the holder the right (but not the obligation) to adjust volume of received commodity at her discretion. Unlike paper assets, trading in physical commodities often takes place over time and therefore involves volume as a second key state variable. Often consumption rates of the commodity are unpredictable and make fixed delivery amounts uneconomic. To mitigate such volume risk, a swing contract gives the buyer the opportunity to manage fluctuating commodity demand levels in exchange for a fixed upfront fee. By exercising her swing up/down rights, the buyer can dynamically match supply and demand levels while hedging her costs. Swing options are widely offered by market makers and used extensively by major energy companies, especially in electricity and fossil fuel markets. Contracts with swing features are available both as stand-alone financial tools, and can also be found embedded within structured physical transactions. 1. Definition and Use. A typical definition of a swing option is as follows. At times n = 1, 2, . . . , N the buyer is to receive a baseload amount K̄ of the commodity paying the strike price P̄ . In addition, over the life of the contract, the buyer has Nc ≤ N swing rights to temporarily vary these deliveries, instead requesting to receive an amount kn. This request is usually made on a 1-period ahead basis, so that the supplier has time to adjust his delivery. The swing amount kn is subject to the constraint kmin ≤ kn ≤ kMax, where kmin (resp. kMax) is the minimal (resp. maximal) allowable one-period delivery volume. The timing of these exercises is at the discretion of the buyer. Thus, depending on the needs of the buyer, the amount received can be swung up or down up to Nc times. Let Yn denote the discounted present value of the net cash flow beyond the income expected from the baseload contract, due to the exercise of a swing right on date n. Assuming that the cashflow amount is linear in the swing volume and no other constraints are present, it is optimal to always apply full (bang-bang) volumetric exercise, i.e. kn ∈ {kmin, kMax}. It follows that (1) Yn = e(kn − K̄)(Pn − P̄ ), where Pn is the spot price of the commodity in period n, and r is the discount rate for one period. Note that if the exercise decision was made before n, then Yn in (1) may be negative. Take-or-Pay Provisions. To bound possible swings from the baseload contract, global volume constraints are often imposed. A Take-or-Pay provision adds the constraint Smin ≤ ∑N n=1 kn ≤ SMax, where Smin (resp. SMax) is the minimal (resp. maximal) total volume over the N periods. Thus, the buyer is required to place her total cumulative consumption within a pre-defined volume band. This rule is enforced via penalties on the buyer (hence Take-or-Pay) if the provision is violated. Nomination Contracts. A nomination contract is a variant of a swing option, where the swing amounts are permanent. Thus, changing the nomination amount from K̄ to kn implies that the new baseload amount will be kn for the remainder of the contract. Such ratcheting rules are common in pipeline contracts.