The authors thank the Finance and Sustainable Development Chair sponsored by EDF, CACIB, and CDC for their support.
A STRUCTURAL RISK-NEUTRAL MODEL FOR PRICING AND HEDGING POWER DERIVATIVES
Article first published online: 13 FEB 2012
© 2012 Wiley Periodicals, Inc.
Volume 23, Issue 3, pages 387–438, July 2013
How to Cite
Aïd, R., Campi, L. and Langrené, N. (2013), A STRUCTURAL RISK-NEUTRAL MODEL FOR PRICING AND HEDGING POWER DERIVATIVES. Mathematical Finance, 23: 387–438. doi: 10.1111/j.1467-9965.2011.00507.x
- Issue published online: 8 JUN 2013
- Article first published online: 13 FEB 2012
- Manuscript received October 2010; final revision received May 2011.
- Electricity spot and forward prices;
- electricity demand;
- scarcity function;
- local risk minimization;
- minimal martingale measure;
- power derivatives;
- spread options;
- extended incomplete Goodwin–Staton integral
We develop a structural risk-neutral model for energy market modifying along several directions the approach introduced in Aïd et al. In particular, a scarcity function is introduced to allow important deviations of the spot price from the marginal fuel price, producing price spikes. We focus on pricing and hedging electricity derivatives. The hedging instruments are forward contracts on fuels and electricity. The presence of production capacities and electricity demand makes such a market incomplete. We follow a local risk minimization approach to price and hedge energy derivatives. Despite the richness of information included in the spot model, we obtain closed-form formulae for futures prices and semiexplicit formulae for spread options and European options on electricity forward contracts. An analysis of the electricity price risk premium is provided showing the contribution of demand and capacity to the futures prices. We show that when far from delivery, electricity futures behave like a basket of futures on fuels.