EconPapers    
Economics at your fingertips  
 

The price of power: The valuation of power and weather derivatives

Craig Pirrong and Martin Jermakyan

Journal of Banking & Finance, 2008, vol. 32, issue 12, 2520-2529

Abstract: Pricing contingent claims on power presents numerous challenges due to (1) the unique behavior of power prices, and (2) time-dependent variations in prices. We propose and implement a model in which the spot price of power is a function of two state variables: demand (load) and fuel price. In this model, any power derivative price must satisfy a PDE with boundary conditions that reflect capacity limits and the non-linear relation between load and the spot price of power. Moreover, since power is non-storable and demand is not a traded asset, the power derivative price embeds a market price of risk. Using inverse problem techniques and power forward prices from the PJM market, we solve for this market price of risk function. During 1999-2001, the upward bias in the forward price was as large as $50/MWh for some days in July. By 2005, the largest estimated upward bias had fallen to $19/MWh. These large biases are plausibly due to the extreme right skewness of power prices; this induces left skewness in the payoff to short forward positions, and a large risk premium is required to induce traders to sell power forwards. This risk premium suggests that the power market is not fully integrated with the broader financial markets.

Keywords: Electricity; markets; Derivatives; pricing; Market; price; of; risk; Inverse; techniques (search for similar items in EconPapers)
Date: 2008
References: View references in EconPapers View complete reference list from CitEc
Citations View citations in EconPapers (26) Track citations by RSS feed

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0378-4266(08)00086-1
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:32:y:2008:i:12:p:2520-2529

Access Statistics for this article

Journal of Banking & Finance is currently edited by Ike Mathur

More articles in Journal of Banking & Finance from Elsevier
Series data maintained by Dana Niculescu ().

 
Page updated 2017-09-29
Handle: RePEc:eee:jbfina:v:32:y:2008:i:12:p:2520-2529