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

Author

Listed:
  • René Aïd

    (FiME Lab - Laboratoire de Finance des Marchés d'Energie - Université Paris Dauphine-PSL - PSL - Université Paris sciences et lettres - CREST - EDF R&D - EDF R&D - EDF - EDF, EDF - EDF)

  • Luciano Campi

    (FiME Lab - Laboratoire de Finance des Marchés d'Energie - Université Paris Dauphine-PSL - PSL - Université Paris sciences et lettres - CREST - EDF R&D - EDF R&D - EDF - EDF, CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - Université Paris Dauphine-PSL - PSL - Université Paris sciences et lettres - CNRS - Centre National de la Recherche Scientifique)

  • Nicolas Langrené

    (FiME Lab - Laboratoire de Finance des Marchés d'Energie - Université Paris Dauphine-PSL - PSL - Université Paris sciences et lettres - CREST - EDF R&D - EDF R&D - EDF - EDF, LPMA - Laboratoire de Probabilités et Modèles Aléatoires - UPMC - Université Pierre et Marie Curie - Paris 6 - UPD7 - Université Paris Diderot - Paris 7 - CNRS - Centre National de la Recherche Scientifique)

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.

Suggested Citation

  • René Aïd & Luciano Campi & Nicolas Langrené, 2010. "A structural risk-neutral model for pricing and hedging power derivatives," Working Papers hal-00525800, HAL.
  • Handle: RePEc:hal:wpaper:hal-00525800
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    References listed on IDEAS

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