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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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Author Info

  • Benth, Fred Espen
  • Cartea, Álvaro
  • Kiesel, Rüdiger

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 and the interaction between buyers and sellers. In commodities markets this premium is an important indicator of the behavior 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. We apply our model to the German electricity market and show that the market risk premium exhibits a term structure which can be explained by the combination of two factors. Firstly, the levels of risk aversion of buyers and sellers, and secondly, how the market power of producers, relative to that of buyers, affects forward prices with different delivery periods

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File URL: http://e-archivo.uc3m.es/bitstream/10016/12158/1/pricing_cartea_JBF_2008_ps.pdf
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Bibliographic Info

Paper provided by Universidad Carlos III de Madrid in its series Open Access publications from Universidad Carlos III de Madrid with number info:hdl:10016/12158.

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Length: 2023 p.
Date of creation: Oct 2008
Date of revision:
Publication status: Published in Journal of Banking & Finance (2008-10) v.v. 32, p.2006-2021
Handle: RePEc:ner:carlos:info:hdl:10016/12158

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Web page: http://www.uc3m.es

Related research

Keywords: Contango; Backwardation; Market price of risk; Electricity forwards; Market risk premium; Forward risk premium; Forward bias; Market power;

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References

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  1. Cartea, Álvaro & Figueroa, Marcelo G., 2005. "Pricing in electricity markets : a mean reverting jump diffusion model with seasonality," Open Access publications from Universidad Carlos III de Madrid info:hdl:10016/12199, Universidad Carlos III de Madrid.
  2. 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.
  3. 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.
  4. 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.
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Citations

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Cited by:
  1. María Dolores Furió & Vicente Meneu, 2009. "Expectations and Forward Risk Premium in the Spanish Power Market," Working Papers. Serie AD 2009-02, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  2. Cartea, Álvaro & Villaplana, Pablo, . "Spot price modeling and the valuation of electricity forward contracts : the role of demand and capacity," Open Access publications from Universidad Carlos III de Madrid info:hdl:10016/12082, Universidad Carlos III de Madrid.
  3. Weron, Rafal, 2008. "Market price of risk implied by Asian-style electricity options and futures," Energy Economics, Elsevier, vol. 30(3), pages 1098-1115, May.
  4. Marckhoff, Jan & Wimschulte, Jens, 2009. "Locational price spreads and the pricing of contracts for difference: Evidence from the Nordic market," Energy Economics, Elsevier, vol. 31(2), pages 257-268, March.
  5. Benth, Fred Espen & Koekebakker, Steen, 2008. "Stochastic modeling of financial electricity contracts," Energy Economics, Elsevier, vol. 30(3), pages 1116-1157, May.
  6. Pietz, Matthäus, 2009. "Risk premia in electricity wholesale spot markets: empirical evidence from Germany," CEFS Working Paper Series 2009-11, Center for Entrepreneurial and Financial Studies (CEFS), Technische Universität München.
  7. Fred Espen Benth & Claudia Kl\"uppelberg & Gernot M\"uller & Linda Vos, 2012. "Futures pricing in electricity markets based on stable CARMA spot models," Papers 1201.1151, arXiv.org.
  8. Joanna Janczura & Rafał Weron, 2012. "Efficient estimation of Markov regime-switching models: An application to electricity spot prices," AStA Advances in Statistical Analysis, Springer, vol. 96(3), pages 385-407, July.
  9. Gr\'egory Benmenzer & Emmanuel Gobet & C\'eline J\'erusalem, 2007. "Arbitrage free cointegrated models in gas and oil future markets," Papers 0712.3537, arXiv.org.
  10. Almut E. D. Veraart & Luitgard A. M. Veraart, 2013. "Risk premia in energy markets," CREATES Research Papers 2013-02, School of Economics and Management, University of Aarhus.
  11. Rubin, Ofir D. & Babcock, Bruce A., 2011. "A novel approach for modeling deregulated electricity markets," Energy Policy, Elsevier, vol. 39(5), pages 2711-2721, May.
  12. Viehmann, Johannes, 2011. "Risk premiums in the German day-ahead Electricity Market," Energy Policy, Elsevier, vol. 39(1), pages 386-394, January.
  13. Weron, Rafal & Janczura, Joanna, 2010. "Efficient estimation of Markov regime-switching models: An application to electricity wholesale market prices," MPRA Paper 26628, University Library of Munich, Germany.
  14. Fred Espen Benth & Jukka Lempa, 2012. "Optimal portfolios in commodity futures markets," Papers 1204.2667, arXiv.org.
  15. Pietz, Matthäus, 2009. "Risk premia in the German electricity futures market," CEFS Working Paper Series 2009-07, Center for Entrepreneurial and Financial Studies (CEFS), Technische Universität München.
  16. Joanna Janczura, 2012. "Pricing electricity derivatives within a Markov regime-switching model," Papers 1203.5442, arXiv.org.

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