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Jump-diffusion modeling in emission markets

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

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    File URL: http://arxiv.org/pdf/1001.3728
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1001.3728.

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    Date of creation: Jan 2010
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    Handle: RePEc:arx:papers:1001.3728

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    Web page: http://arxiv.org/

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    1. Paul Leiby & Jonathan Rubin, 2001. "Intertemporal Permit Trading for the Control of Greenhouse Gas Emissions," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 19(3), pages 229-256, July.
    2. Montgomery, W. David, 1972. "Markets in licenses and efficient pollution control programs," Journal of Economic Theory, Elsevier, vol. 5(3), pages 395-418, December.
    3. Schennach, Susanne M., 2000. "The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments," Journal of Environmental Economics and Management, Elsevier, vol. 40(3), pages 189-210, November.
    4. Rubin, Jonathan D., 1996. "A Model of Intertemporal Emission Trading, Banking, and Borrowing," Journal of Environmental Economics and Management, Elsevier, vol. 31(3), pages 269-286, November.
    5. Cronshaw, Mark B & Brown-Kruse, Jamie, 1996. "Regulated Firms in Pollution Permit Markets with Banking," Journal of Regulatory Economics, Springer, vol. 9(2), pages 179-89, March.
    6. Seifert, Jan & Uhrig-Homburg, Marliese & Wagner, Michael, 2008. "Dynamic behavior of CO2 spot prices," Journal of Environmental Economics and Management, Elsevier, vol. 56(2), pages 180-194, September.
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