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Short-term evolution of forward curves and volatility in illiquid power market

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  • Vázquez, Miguel
  • Sánchez-Úbeda, Eugenio F.
  • Berzosa, Ana
  • Barquín, Julián

Abstract

We propose in this paper a model for the description of electricity spot prices, which we use to describe the dynamics of forward curves. The spot price model is based on a long-term/short-term decomposition, where the price is thought of as made up of two factors: A long-term equilibrium level and short-term movements around the equilibrium. We use a non-parametric approach to model the equilibrium level of power prices, and a mean-reverting process with GARCH volatility to describe the dynamics of the short-term component. Then, the model is used to derive the expression of the short-term dynamics of the forward curve implicit in spot prices. The rationale for the approach is that information concerning forward prices is not available in most of power markets, and the direct modeling of the forward curve is a difficult task. Moreover, power derivatives are typically written on forward contracts, and usually based on average prices of forward contracts. Then, it is difficult to obtain analytical expressions for the forward curves. The model of forward prices allows for the valuation of power derivatives, as well as the calculation of the volatilities and correlations required in risk management activities. Finally, the methodology is proven in the context of the Spanish wholesale market

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 8932.

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Date of creation: Feb 2008
Date of revision: May 2008
Handle: RePEc:pra:mprapa:8932

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Keywords: Forward curves; Power Markets; GARCH volatility; nonparametric regression;

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  1. 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.
  2. Steven L. Heston & Saikat Nandi, 1997. "A closed-form GARCH option pricing model," Working Paper 97-9, Federal Reserve Bank of Atlanta.
  3. Les Clewlow & Chris Strickland, 1999. "A Multi-Factor Model for Energy Derivatives," Research Paper Series 28, Quantitative Finance Research Centre, University of Technology, Sydney.
  4. René Garcia & Eric Ghysels & Éric Renault, 2004. "The Econometrics of Option Pricing," CIRANO Working Papers 2004s-04, CIRANO.
  5. Svetlana Borovkova, 2006. "Detecting market transitions and energy futures risk management using principal components," European Journal of Finance, Taylor and Francis Journals, vol. 12(6-7), pages 495-512.
  6. Alvaro Escribano & J. Ignacio Peña & Pablo Villaplana, 2011. "Modelling Electricity Prices: International Evidence," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 73(5), pages 622-650, October.
  7. 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.
  8. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
  9. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
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