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Analysis of model implied volatility for jump diffusion models: Empirical evidence from the Nordpool market

  • Nomikos, Nikos K.
  • Soldatos, Orestes A.
Registered author(s):

    In this paper we examine the importance of mean reversion and spikes in the stochastic behaviour of the underlying asset when pricing options on power. We propose a model that is flexible in its formulation and captures the stylized features of power prices in a parsimonious way. The main feature of the model is that it incorporates two different speeds of mean reversion to capture the differences in price behaviour between normal and spiky periods. We derive semi-closed form solutions for European option prices using transform analysis and then examine the properties of the implied volatilities that the model generates. We find that the presence of jumps generates prominent volatility skews which depend on the sign of the mean jump size. We also show that mean reversion reduces the volatility smile as time to maturity increases. In addition, mean reversion induces volatility skews particularly for ITM options, even in the absence of jumps. Finally, jump size volatility and jump intensity mainly affect the kurtosis and thus the curvature of the smile with the former having a more important role in making the volatility smile more pronounced and thus increasing the kurtosis of the underlying price distribution.

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    Article provided by Elsevier in its journal Energy Economics.

    Volume (Year): 32 (2010)
    Issue (Month): 2 (March)
    Pages: 302-312

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    Handle: RePEc:eee:eneeco:v:32:y:2010:i:2:p:302-312
    Contact details of provider: Web page: http://www.elsevier.com/locate/eneco

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    1. Alvaro Escribano & Juan Ignacio Peña & Pablo Villaplana, 2002. "Modeling Electricity Prices: International Evidence," Economics Working Papers we022708, Universidad Carlos III, Departamento de Economía.
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    15. Longstaff, Francis & Wang, Ashley, 2002. "Electricity Forward Prices: A High-Frequency Empirical Analysis," University of California at Los Angeles, Anderson Graduate School of Management qt7mh2m2bt, Anderson Graduate School of Management, UCLA.
    16. 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.
    17. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
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