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

• Published in: Mathematical methods of operations research (Heidelberg, Germany) Vol. 79; no. 1; pp. 1 - 30
• Main Author: Janczura, Joanna
• Format: Journal Article
• Language: English
• Published: Berlin/Heidelberg Springer Berlin Heidelberg 01.02.2014; Springer Nature B.V
• Subjects: Business and Management; Calculus of Variations and Optimal Control; Optimization; Calibration; Commodities; Data analysis; Derivatives; Economic models; Economic statistics; Economic theory; Electricity; Electricity generation; Energy economics; Markov models; Mathematical analysis; Mathematical models; Mathematics; Mathematics and Statistics; Operations research; Operations Research/Decision Theory; Options markets; Original Article; Pricing; Pricing policies; Risk; Risk premiums; Studies; Time series; Risk premium; Electricity spot price; Regime-switching model; Derivatives pricing
• ISSN: 1432-2994; 1432-5217
• DOI: 10.1007/s00186-013-0451-8

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.