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Risk premia in energy markets

Author

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  • Almut E. D. Veraart

    () (Imperial College London and CREATES)

  • Luitgard A. M. Veraart

    () (London School of Economics)

Abstract

Risk premia between spot and forward prices play a key role in energy markets. This paper derives analytic expressions for such risk premia when spot prices are modelled by Lévy semistationary processes. While the relation between spot and forward prices can be derived using classical no-arbitrage arguments as long as the underlying commodities are storable, the situation changes in the case of electricity. Hence, in an empirical study based on electricity spot prices and futures from the European Energy Exchange market, we investigate the empirical behaviour of electricity risk premia from a statistical perspective. We find that a model-based prediction of the spot price has some explanatory power for the corresponding forward price, but there is a significant additional amount of variability, the risk premium, which needs to be accounted for. We demonstrate how a suitable model for electricity forward prices can be formulated and we obtain promising empirical results.

Suggested Citation

  • Almut E. D. Veraart & Luitgard A. M. Veraart, 2013. "Risk premia in energy markets," CREATES Research Papers 2013-02, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2013-02
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    File URL: ftp://ftp.econ.au.dk/creates/rp/13/rp13_02.pdf
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    References listed on IDEAS

    as
    1. Almut E. D. Veraart, 2011. "Likelihood estimation of Lévy‐driven stochastic volatility models through realized variance measures," Econometrics Journal, Royal Economic Society, vol. 14(2), pages 204-240, July.
    2. Benth, Fred Espen & Cartea, Álvaro & Kiesel, Rüdiger, 2008. "Pricing forward contracts in power markets by the certainty equivalence principle: Explaining the sign of the market risk premium," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2006-2021, October.
    3. Ole E. Barndorff-Nielsen & Fred Espen Benth & Almut E. D. Veraart, 2013. "Modelling energy spot prices by volatility modulated L\'{e}vy-driven Volterra processes," Papers 1307.6332, arXiv.org.
    4. Barndorff-Nielsen, Ole E. & Benth, Fred Espen & Pedersen, Jan & Veraart, Almut E.D., 2014. "On stochastic integration for volatility modulated Lévy-driven Volterra processes," Stochastic Processes and their Applications, Elsevier, vol. 124(1), pages 812-847.
    5. Iivo Vehvilainen, 2002. "Basics of electricity derivative pricing in competitive markets," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 45-60.
    6. 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, June.
    7. Ole E. Barndorff-Nielsen & Shephard, 2002. "Econometric analysis of realized volatility and its use in estimating stochastic volatility models," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 64(2), pages 253-280.
    8. Lucia, Julio J. & Torró, Hipòlit, 2011. "On the risk premium in Nordic electricity futures prices," International Review of Economics & Finance, Elsevier, vol. 20(4), pages 750-763, October.
    9. Almut E. D. Veraart & Luitgard A. M. Veraart, 2012. "Modelling electricity day–ahead prices by multivariate Lévy semistationary processes," CREATES Research Papers 2012-13, Department of Economics and Business Economics, Aarhus University.
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    More about this item

    Keywords

    Lévy semistationary process; energy market; spot price; forward price; futures; risk premia; stochastic volatility; European Energy Exchange market.;

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G00 - Financial Economics - - General - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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