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Modelling Electricity Swaps with Stochastic Forward Premium Models

Abstract:
We present a new model for pricing electricity swaps. Two general factors affect contracts but unique risk elements affect each contract. General factors are average swap prices and deterministic trend-seasonal components, and unique elements are forward premiums. Innovations follow MNIG distributions. We estimate the model with data from the European Energy Exchange. The model outperforms four competitors, both in in-sample valuation and in out-of-sample forecasting, and in fitting the term structure of volatilities by market segments. Competitor models are (i) diffusion spot prices, (ii) jump-diffusion spot prices with time dependent volatility, (iii) HJM-based and (iv) Levy multifactor model with NIG distributions. Value-at-Risk measures based on normality strongly underestimate tail risk but our model gives estimates that are more exact.

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Energy Specializations: Electricity – Markets and Prices ; Energy Investment and Finance – Public and Private Risks, Risk Management; Energy Modeling – Energy Data, Modeling, and Policy Analysis

JEL Codes:
D42 - Market Structure, Pricing, and Design: Monopoly
D81 - Criteria for Decision-Making under Risk and Uncertainty
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination

Keywords: Electricity swaps, Stochastic forward premium. Multivariate Normal Inverse Gaussian distribution, Lévy processes

DOI: 10.5547/01956574.39.2.ibla

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Published in Volume 39, Number 2 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.