Pricing electricity derivatives within a Markov regime-switching model: a risk premium approach

Abstract

In this paper we derive analytic formulas for electricity derivatives under assumption that electricity spot prices follow a 3-regime Markov regime-switching model with independent spikes and drops and periodic transition matrix. Since the classical derivatives pricing methodology cannot be used in the case of non-storable commodities, we employ the concept of the risk premium. The obtained theoretical results are then used for the European Energy Exchange data analysis. We calculate the risk premium in the case of the calibrated 3-regime MRS model. We find a time varying structure of the risk premium and an evidence for a negative risk premium (or positive forward premium), especially at short times before delivery. Finally, we use the obtained risk premium to calculate prices of European options written on spot, as well as, forward prices.

On the importance of the long-term seasonal component in day-ahead electricity price forecasting

“…For midterm horizons -ranging from a few days to a few months ahead and typically considered in derivatives pricing and risk management applications -the daily profile is usually regarded as irrelevant (Ignatieva and Trück, 2016;Janczura, 2014). In fact, most mid-term EPF models work with average daily prices and focus on the annual or long-term seasonal component (LTSC; also called the trend-seasonal component).…”

Revisiting the relationship between spot and futures prices in the Nord Pool electricity market

“…It is therefore important to be able to identify and estimate the components of the premia implied by forward electricity prices. However, in spite of an increasing amount of literature (see also Benth et al, 2008b;Bessembinder and Lemmon, 2002;Bunn and Chen, 2013;Diko et al, 2006;Douglas and Popova, 2008;Handika and Trueck, 2013;Haugom and Ullrich, 2012;Huisman and Kilic, 2012;Janczura, 2013;Longstaff and Wang, 2004;Karakatsani and Bunn, 2005;Kolos and Ronn, 2008;Redl et al, 2009;Ronn and Wimschulte, 2009;Weron, 2008), this topic remains a challenging and relatively unresolved area of research. Much of this has to do with the confusion around the terminology in published research (more details in the next Section).…”

Valuation of Swing Options under a Regime‐Switching Mean‐Reverting Model

“…Note that the fair price of the swing option in Definition 2 is the discounted expected future payoff under a martingale measure Q. In order to find Q, we apply the risk premium approach proposed in [37,38]. Define the risk premium as 0 1 2 3 0 1 2 3 0 1 2 where P is the expectation under the physical measure P and0 is the price of future contract at present time 0 with the delivery timê.…”

“…With fl (̂= | 0 = 2). Similar to [38], we assume that According to [38], we should rewrite (38) ( 1 , 2 )…”

“…(̂|̂= , F 0 )= −̂0 + (1 − −̂) − (1 − −̂) ,By substitute (A.2) and (A.5) into the expression of the risk premium defined in(38), we get an equation connecting (̂) and , which is given by(̂) = (̂) P (̂|̂= , F 0 ) − Q (̂|̂= , 11F 0 )) = (̂)…”