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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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  • Fred Espen Benth
  • Alvaro Cartea

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Ruediger Kiesel

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. In commodities markets this premium is an important indicator of the behaviour 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.

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File URL: http://www.ems.bbk.ac.uk/research/wp/PDF/BWPEF0611.pdf
File Function: First version, 2006
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Bibliographic Info

Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0611.

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Date of creation: Oct 2006
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Handle: RePEc:bbk:bbkefp:0611

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Related research

Keywords: Contango; backwardation; market price of risk; electricity forwards; market risk premium; forward risk premium; forward bias.;

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  1. 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.
  2. 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.
  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.
  4. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, vol. 46(7), pages 893-911, July.
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