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Option Formulas for Mean-Reverting Power Prices with Spikes

  • de Jong, C.M.
  • Huisman, R.
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    Electricity prices are known to be very volatile and subject to frequent jumps due to system breakdown, demand shocks, and inelastic supply. Appropriate pricing, portfolio, and risk management models should incorporate these spikes. We develop a framework to price European-style options that are consistent with the possibility of market spikes. The pricing framework is based on a regime jump model that disentangles mean-reversion from the spikes. In the model the spikes are truly time-specific events and therefore independent from the mean-reverting price process. This closely resembles the characteristics of electricity prices, as we show with Dutch APX spot price data in the period January 2001 till June 2002. Thanks to the independence of the two price processes in the model, we break derivative prices down in a mean-reverting value and a spike value. We use this result to show how the model can be made consistent with forward prices in the market and present closed-form formulas for European-style options.

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    Paper provided by Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam in its series ERIM Report Series Research in Management with number ERS-2002-96-F&A.

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    Date of creation: 22 Oct 2002
    Date of revision:
    Handle: RePEc:ems:eureri:242
    Contact details of provider: Postal: RSM Erasmus University & Erasmus School of Economics, PoBox 1738, 3000 DR Rotterdam
    Phone: 31-10-408 1182
    Fax: 31-10-408 9020
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    1. Hilliard, Jimmy E. & Reis, Jorge, 1998. "Valuation of Commodity Futures and Options under Stochastic Convenience Yields, Interest Rates, and Jump Diffusions in the Spot," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(01), pages 61-86, March.
    2. Robert S. Pindyck, 1999. "The Long-Run Evolutions of Energy Prices," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2), pages 1-27.
    3. Miltersen, Kristian R. & Schwartz, Eduardo S., 1998. "Pricing of Options on Commodity Futures with Stochastic Term Structures of Convenience Yields and Interest Rates," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(01), pages 33-59, March.
    4. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
    5. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-47.
    6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    7. Longstaff, Francis A. & Santa-Clara, Pedro & Schwartz, Eduardo S., 2001. "Throwing away a billion dollars: the cost of suboptimal exercise strategies in the swaptions market," Journal of Financial Economics, Elsevier, vol. 62(1), pages 39-66, October.
    8. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    9. 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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