Short-term evolution of forward curves and volatility in illiquid power market

Miguel Vazquez (), Eugenio F. Sánchez-Úbeda, Ana Berzosa and Julián Barquín

MPRA Paper from University Library of Munich, Germany

Abstract: We propose in this paper a model for the description of electricity spot prices, which we use to describe the dynamics of forward curves. The spot price model is based on a long-term/short-term decomposition, where the price is thought of as made up of two factors: A long-term equilibrium level and short-term movements around the equilibrium. We use a non-parametric approach to model the equilibrium level of power prices, and a mean-reverting process with GARCH volatility to describe the dynamics of the short-term component. Then, the model is used to derive the expression of the short-term dynamics of the forward curve implicit in spot prices. The rationale for the approach is that information concerning forward prices is not available in most of power markets, and the direct modeling of the forward curve is a difficult task. Moreover, power derivatives are typically written on forward contracts, and usually based on average prices of forward contracts. Then, it is difficult to obtain analytical expressions for the forward curves. The model of forward prices allows for the valuation of power derivatives, as well as the calculation of the volatilities and correlations required in risk management activities. Finally, the methodology is proven in the context of the Spanish wholesale market

Keywords: Forward curves; Power Markets; GARCH volatility; nonparametric regression (search for similar items in EconPapers)
JEL-codes: C14 C15 C32 D81 D84 (search for similar items in EconPapers)
Date: 2008-02, Revised 2008-05
New Economics Papers: this item is included in nep-ecm, nep-fmk and nep-ore
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https://mpra.ub.uni-muenchen.de/8954/1/MPRA_paper_8954.pdf revised version (application/pdf)
https://mpra.ub.uni-muenchen.de/9448/1/MPRA_paper_9448.pdf revised version (application/pdf)

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