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A pricing measure to explain the risk premium in power markets

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  • Fred Espen Benth
  • Salvador Ortiz-Latorre

Abstract

In electricity markets, it is sensible to use a two-factor model with mean reversion for spot prices. One of the factors is an Ornstein-Uhlenbeck (OU) process driven by a Brownian motion and accounts for the small variations. The other factor is an OU process driven by a pure jump L\'evy process and models the characteristic spikes observed in such markets. When it comes to pricing, a popular choice of pricing measure is given by the Esscher transform that preserves the probabilistic structure of the driving L\'evy processes, while changing the levels of mean reversion. Using this choice one can generate stochastic risk premiums (in geometric spot models) but with (deterministically) changing sign. In this paper we introduce a pricing change of measure, which is an extension of the Esscher transform. With this new change of measure we also can slow down the speed of mean reversion and generate stochastic risk premiums with stochastic non constant sign, even in arithmetic spot models. In particular, we can generate risk profiles with positive values in the short end of the forward curve and negative values in the long end. Finally, our pricing measure allows us to have a stationary spot dynamics while still having randomly fluctuating forward prices for contracts far from maturity.

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  • Fred Espen Benth & Salvador Ortiz-Latorre, 2013. "A pricing measure to explain the risk premium in power markets," Papers 1308.3378, arXiv.org.
    • Handle: RePEc:arx:papers:1308.3378
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    References listed on IDEAS

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    1. Albert N. Shiryaev & Jan Kallsen, 2002. "The cumulant process and Esscher's change of measure," Finance and Stochastics, Springer, vol. 6(4), pages 397-428.
    2. 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.
    3. 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.
    4. Alvaro Cartea & Marcelo Figueroa, 2005. "Pricing in Electricity Markets: A Mean Reverting Jump Diffusion Model with Seasonality," Applied Mathematical Finance, Taylor & Francis Journals, vol. 12(4), pages 313-335.
    5. 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.
    6. Gibson, Rajna & Schwartz, Eduardo S, 1990. "Stochastic Convenience Yield and the Pricing of Oil Contingent Claims," Journal of Finance, American Finance Association, vol. 45(3), pages 959-976, July.
    7. 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.
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    Cited by:

    1. Fred Espen Benth & Salvador Ortiz-Latorre, 2014. "A change of measure preserving the affine structure in the BNS model for commodity markets," Papers 1403.5236, arXiv.org.

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