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Pricing forward contracts in power markets by the certainty equivalence principle: Explaining the sign of the market risk premium

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Author Info
Benth, Fred Espen
Cartea, Álvaro
Kiesel, Rüdiger

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Abstract

In this paper we provide a framework that explains how the market risk premium, defined as the difference between forward prices and spot forecasts, depends on the risk preferences of market players and the interaction between buyers and sellers. In commodities markets this premium is an important indicator of the behavior of buyers and sellers and their views on the market spanning between short-term and long-term horizons. We show that under certain assumptions it is possible to derive explicit solutions that link levels of risk aversion and market power with market prices of risk and the market risk premium. We apply our model to the German electricity market and show that the market risk premium exhibits a term structure which can be explained by the combination of two factors. Firstly, the levels of risk aversion of buyers and sellers, and secondly, how the market power of producers, relative to that of buyers, affects forward prices with different delivery periods.

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File URL: http://www.sciencedirect.com/science/article/B6VCY-4RGTXD1-1/2/1ffdef01d1eb42ea18e27dc6dd0b82c7
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Publisher Info
Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 32 (2008)
Issue (Month): 10 (October)
Pages: 2006-2021
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Handle: RePEc:eee:jbfina:v:32:y:2008:i:10:p:2006-2021

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Related research
Keywords: G13 G11 D81 Q40 Contango Backwardation Market price of risk Electricity forwards Market risk premium Forward risk premium Forward bias Market power;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Alvaro Cartea & Marcelo Gustavo Figueroa, 2005. "Pricing in Electricity Markets: a Mean Reverting Jump Diffusion Model with Seasonality," Birkbeck Working Papers in Economics and Finance 0507, Birkbeck, Department of Economics, Mathematics & Statistics. [Downloadable!]
    Other versions:
  2. Alvaro Cartea & Thomas Williams, 2006. "UK Gas Markets: the Market Price of Risk and Applications to Multiple Interruptible Supply Contracts," Birkbeck Working Papers in Economics and Finance 0608, Birkbeck, Department of Economics, Mathematics & Statistics. [Downloadable!]
    Other versions:
  3. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Gr\'egory Benmenzer & Emmanuel Gobet & C\'eline J\'erusalem, 2007. "Arbitrage free cointegrated models in gas and oil future markets," Quantitative Finance Papers 0712.3537, arXiv.org. [Downloadable!]
  2. María Dolores Furió & Vicente Meneu, 2009. "Expectations and Forward Risk Premium in the Spanish Power Market," Working Papers. Serie AD 2009-02, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie). [Downloadable!]
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