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Jump-diffusion modeling in emission markets

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  • K. Borovkov
  • G. Decrouez
  • J. Hinz

Abstract

Mandatory emission trading schemes are being established around the world. Participants of such market schemes are always exposed to risks. This leads to the creation of an accompanying market for emission-linked derivatives. To evaluate the fair prices of such financial products, one needs appropriate models for the evolution of the underlying assets, emission allowance certificates. In this paper, we discuss continuous time diffusion and jump-diffusion models, the latter enabling one to model information shocks that cause jumps in allowance prices. We show that the resulting martingale dynamics can be described in terms of non-linear partial differential and integro-differential equations and use a finite difference method to investigate numerical properties of their discretizations. The results are illustrated by a small numerical study.

Suggested Citation

  • K. Borovkov & G. Decrouez & J. Hinz, 2010. "Jump-diffusion modeling in emission markets," Papers 1001.3728, arXiv.org.
    • Handle: RePEc:arx:papers:1001.3728
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    References listed on IDEAS

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    2. Luca Taschini, 2010. "Environmental Economics and Modeling Marketable Permits," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 17(4), pages 325-343, December.
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    Cited by:

    1. Chang-Yi Li & Son-Nan Chen & Shih-Kuei Lin, 2016. "Pricing derivatives with modeling CO emission allowance using a regime-switching jump diffusion model: with regime-switching risk premium," The European Journal of Finance, Taylor & Francis Journals, vol. 22(10), pages 887-908, August.
    2. Chris Kenyon & Mourad Berrahoui & Andrea Macrina, 2022. "Transparency principle for carbon emissions drives sustainable finance," Papers 2202.07689, arXiv.org.

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