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Does the Black-Scholes formula work for electricity markets? A nonparametric approach

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  • Hjalmarsson, Erik

    ()
    (Department of Economics, School of Economics and Commercial Law, Göteborg University)

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    Abstract

    Despite the high volatilities recorded for electricity prices, there seems to be little demand for options on electricity. One reason for the disinterest in electricity options could arise from uncertainty about how to price these options. This study uses recent econometric advances to nonparametrically estimate correct prices for electricity options and compare these to the Black-Scholes prices. The main finding is that although the nonparametric estimates deviate significantly from the Black-Scholes prices, it would be diffcult to find an alternative parametric model that performs better. Thus, from a practical viewpoint, the Black-Scholes prices appear to be the best available.

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    File URL: http://hdl.handle.net/2077/2809
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    Bibliographic Info

    Paper provided by University of Gothenburg, Department of Economics in its series Working Papers in Economics with number 101.

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    Length: 65 pages
    Date of creation: 31 Jul 2003
    Date of revision:
    Handle: RePEc:hhs:gunwpe:0101

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    Postal: Department of Economics, School of Business, Economics and Law, University of Gothenburg, Box 640, SE 405 30 GÖTEBORG, Sweden
    Phone: 031-773 10 00
    Web page: http://www.handels.gu.se/econ/
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    Keywords: Electricity markets; Nonparametric estimation; Option pricing;

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    1. Knittel, Christopher R. & Roberts, Michael R., 2005. "An empirical examination of restructured electricity prices," Energy Economics, Elsevier, vol. 27(5), pages 791-817, September.
    2. Sanjiv R. Das, 1998. "Poisson-Guassian Processes and the Bond Markets," NBER Working Papers 6631, National Bureau of Economic Research, Inc.
    3. Wolfgang Hardle & Oliver Linton, 1994. "Applied Nonparametric Methods," Cowles Foundation Discussion Papers 1069, Cowles Foundation for Research in Economics, Yale University.
    4. Ait-Sahalia, Yacine, 1996. "Testing Continuous-Time Models of the Spot Interest Rate," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 385-426.
    5. Federico M. Bandi & Peter C.B. Phillips, 2001. "Fully Nonparametric Estimation of Scalar Diffusion Models," Cowles Foundation Discussion Papers 1332, Cowles Foundation for Research in Economics, Yale University.
    6. Gallant, A. Ronald & Hsu, Chien-Te & Tauchen, George, 2000. "Using Daily Range Data to Calibrate Volatility Diffusions and Extract the Forward Integrated Variance," Working Papers 00-04, Duke University, Department of Economics.
    7. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    8. Malcolm P. Baker & E. Scott Mayfield & John E. Parsons, 1998. "Alternative Models of Uncertain Commodity Prices for Use with Modern Asset Pricing Methods," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1), pages 115-148.
    9. Bandi, Federico & Moloche, Guillermo, 2008. "On the functional estimation of multivariate diffusion processes," MPRA Paper 43681, University Library of Munich, Germany.
    10. Hendrik Bessembinder & Michael L. Lemmon, 2002. "Equilibrium Pricing and Optimal Hedging in Electricity Forward Markets," Journal of Finance, American Finance Association, vol. 57(3), pages 1347-1382, 06.
    11. Ball, Clifford A. & Torous, Walter N., 1983. "A Simplified Jump Process for Common Stock Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 18(01), pages 53-65, March.
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    Cited by:
    1. Twomey, Paul & Neuhoff, Karsten, 2010. "Wind power and market power in competitive markets," Energy Policy, Elsevier, vol. 38(7), pages 3198-3210, July.
    2. Twomey, P. & Neuhoff, K., 2005. "Market Power and Technological Bias: The Case of Electricity Generation," Cambridge Working Papers in Economics 0532, Faculty of Economics, University of Cambridge.

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