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A structural risk-neutral model for pricing and hedging power derivatives

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Author Info

  • René Aid

    (FiME - Laboratoire de Finance des Marchés d'Energies - Université Paris Dauphine - Paris IX, EDF R&D - EDF)

  • Luciano Campi

    ()
    (FiME - Laboratoire de Finance des Marchés d'Energies - Université Paris Dauphine - Paris IX, CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - CNRS : UMR7534 - Université Paris Dauphine - Paris IX)

  • Nicolas Langrené

    (FiME - Laboratoire de Finance des Marchés d'Energies - Université Paris Dauphine - Paris IX, PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII)

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    Abstract

    We develop a structural risk-neutral model for energy market modifying along several directions the approach introduced in Aid et al. (2009). In particular a scarcity function is introduced to allow important deviations of the spot price from the marginal fuel price, producing price spikes. We focus on pricing and hedging electricity derivatives. The hedging instruments are forward contracts on fuels and electricity. The presence of production capacities and electricity demand makes such a market incomplete. We follow a local risk minimization approach to price and hedge energy derivatives. Despite the richness of information included in the spot model, we obtain closed-form formulae for futures prices and semi-explicit formulae for spread options and European options on electricity forward contracts. An analysis of the electricity price risk premium is provided showing the contribution of demand and capacity to the futures prices. We show that when far from delivery, electricity futures behave like a basket of futures on fuels.

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    Bibliographic Info

    Paper provided by HAL in its series Working Papers with number hal-00525800.

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    Date of creation: 12 Oct 2010
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    Handle: RePEc:hal:wpaper:hal-00525800

    Note: View the original document on HAL open archive server: http://hal.archives-ouvertes.fr/hal-00525800/en/
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    Web page: http://hal.archives-ouvertes.fr/

    Related research

    Keywords: Electricity spot and forward prices ; Fuels ; Capacity ; Electricity demand ; Scarcity function ; Local risk minimization ; Minimal martingale measure ; Power derivatives ; Spread options ; Extended incomplete Goodwin-Staton integral;

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