In Part III we addressed a series of problems that focused almost exclusively on structures with payoffs depending on the price process of a single underlying contract. Single-factor models were sufficient to establish reasonable valuation and to craft hedging programs provided that sensible decisions were made regarding model form and calibration.

Many franchise and merchant energy desks confront far more complex situations, including structures that depend in a nontrivial way on multiple forward prices and options structures with exercise mechanics on a range of time scales. A simplistic approach is to push the use of single-factor models to more complex situations, approximating multiple contract payoffs as arising from the dynamics of a single diffusion and using entirely separate models for different settings even if these are obviously closely related.

Multifactor models can provide (somewhat) holistic frameworks for valuation of large classes of related structures. The resulting benefit is that comparable risk metrics and hedging programs can be used for portfolios consisting of a broad set of trade types.

We will start by discussing the motivations for the deployment of multifactor models in the context of energy structures. This will be followed by the introduction of a standard Gaussian multifactor forward model that maintains a high degree of tractability while dramatically increasing the types of structures that can be handled collectively. We will conclude with a survey of various multifactor modeling paradigms, the relationships between them, and their relative strengths and weaknesses.