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Risk premia in energy markets

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  • Almut E. D. Veraart

    ()
    (Imperial College London and CREATES)

  • Luitgard A. M. Veraart

    ()
    (London School of Economics)

Abstract

Risk premia between spot and forward prices play a key role in energy markets. This paper derives analytic expressions for such risk premia when spot prices are modelled by Lévy semistationary processes. While the relation between spot and forward prices can be derived using classical no-arbitrage arguments as long as the underlying commodities are storable, the situation changes in the case of electricity. Hence, in an empirical study based on electricity spot prices and futures from the European Energy Exchange market, we investigate the empirical behaviour of electricity risk premia from a statistical perspective. We find that a model-based prediction of the spot price has some explanatory power for the corresponding forward price, but there is a significant additional amount of variability, the risk premium, which needs to be accounted for. We demonstrate how a suitable model for electricity forward prices can be formulated and we obtain promising empirical results.

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Bibliographic Info

Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2013-02.

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Length: 28
Date of creation: 24 Jan 2013
Date of revision:
Handle: RePEc:aah:create:2013-02

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Web page: http://www.econ.au.dk/afn/

Related research

Keywords: Lévy semistationary process; energy market; spot price; forward price; futures; risk premia; stochastic volatility; European Energy Exchange market.;

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References

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  1. Ole E. Barndorff-Nielsen & Neil Shephard, 2000. "Econometric analysis of realised volatility and its use in estimating stochastic volatility models," Economics Papers, Economics Group, Nuffield College, University of Oxford 2001-W4, Economics Group, Nuffield College, University of Oxford, revised 05 Jul 2001.
  2. Lucia, Julio J. & Torró, Hipòlit, 2011. "On the risk premium in Nordic electricity futures prices," International Review of Economics & Finance, Elsevier, Elsevier, vol. 20(4), pages 750-763, October.
  3. Hendrik Bessembinder & Michael L. Lemmon, 2002. "Equilibrium Pricing and Optimal Hedging in Electricity Forward Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 57(3), pages 1347-1382, 06.
  4. Fred Espen Benth & Alvaro Cartea & Ruediger Kiesel, 2006. "Pricing Forward Contracts in Power Markets by the Certainty Equivalence Principle: Explaining the Sign of the Market Risk Premium," Birkbeck Working Papers in Economics and Finance, Birkbeck, Department of Economics, Mathematics & Statistics 0611, Birkbeck, Department of Economics, Mathematics & Statistics.
  5. Almut E. D. Veraart, 2011. "Likelihood estimation of Lévy‐driven stochastic volatility models through realized variance measures," Econometrics Journal, Royal Economic Society, Royal Economic Society, vol. 14(2), pages 204-240, 07.
  6. Ole E. Barndorff-Nielsen & Fred Espen Benth & Almut E. D. Veraart, 2013. "Modelling energy spot prices by volatility modulated L\'{e}vy-driven Volterra processes," Papers 1307.6332, arXiv.org.
  7. Iivo Vehvilainen, 2002. "Basics of electricity derivative pricing in competitive markets," Applied Mathematical Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 9(1), pages 45-60.
  8. Barndorff-Nielsen, Ole E. & Benth, Fred Espen & Pedersen, Jan & Veraart, Almut E.D., 2014. "On stochastic integration for volatility modulated Lévy-driven Volterra processes," Stochastic Processes and their Applications, Elsevier, Elsevier, vol. 124(1), pages 812-847.
  9. Almut E. D. Veraart & Luitgard A. M. Veraart, 2012. "Modelling electricity day–ahead prices by multivariate Lévy semistationary processes," CREATES Research Papers, School of Economics and Management, University of Aarhus 2012-13, School of Economics and Management, University of Aarhus.
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