Pricing and Hedging Quanto Options in Energy Markets

In energy markets, the use of quanto options have increased significantly in the recent years. The payoff from such options are typically written on an underlying energy index and a measure of temperature and are suited for managing the joint price and volume risk in energy markets. Using an HJM approach we derive a closed form option pricing formula for energy quanto options, under the assumption that the underlying assets are log-normally distributed. Our approach encompasses several interesting cases, such as geometric Brownian motions and multifactor spot models. We also derive delta and gamma expressions for hedging. Furthermore, we illustrate the use of our model by an empirical pricing exercise using NYMEX traded natural gas futures and CME traded Heating Degree Days futures for New York.