ON FORWARD PRICE MODELING IN POWER MARKETS

Fred Espen Benth
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Fred Espen Benth: Centre of Mathematics for Applications, University of Oslo, P.O. Box 1053, Blindern, 0316 Oslo, Norway and University of Agder, School of Management, Serviceboks 422, 4604 Kristiansand, Norway

Chapter 5 in Alternative Investments and Strategies, 2010, pp 93-122 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractPower forward contracts deliver electricity over a specified period, and can be viewed as a portfolio of forwards with maturity at each time instant in the delivery period. We investigate the implied power forward dynamics from a geometric Brownian motion specification of the forward price, which turns out to have a very complicated structure. Lognormal approximations are argued for, and we demonstrate that they work excellently in many situations. In particular, we focus on the approximation suggested by Bjerksund et al. [8], where the volatility of the power forward is simply the average of the fixed maturity forward volatility. Although giving a superior model to the moment matched dynamics, it fails to estimate the tails of the power forward distribution in some cases with extreme volatility and mean-reversion. We provide analytical bounds in terms of geometric Brownian motions for the power forward dynamics, and also compare the covariance structure with those implied by a geometric Brownian motion.

Keywords: Alternative Investments; Portfolio Selection; Trading Strategy; Product Innovations; CPPI; Portfolio Optimization; Portfolio Insurance (search for similar items in EconPapers)
Date: 2010
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