An Arithmetic Modeling Framework for the Term Structure of Electricity Prices
Kees E. Bouwman
Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)
Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute
Dick J. C. Van Dijk
Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute; ERIM
May 13, 2012
We propose a tractable class of arbitrage-free models for the term structure of electricity prices, where spot and forward prices are a linear function of latent factors. The modeling approach offers much flexibility in the specification of the factor dynamics by only restricting their risk-neutral drift. We derive a canonical form where the parameters determining the factor loadings for the forward prices can be separated from the parameters describing the factor dynamics. The factor loading parameters can be consistently estimated by directly fitting the cross-section of forward prices. The modeling framework is applied to a panel of daily prices on forward contracts from the Nordpool electricity market, using affine factor dynamics. We find that forward prices (i) are mainly driven by changes in the level, slope and curvature of the forward curve; (ii) exhibit time-varying volatilities; and (iii) incorporate time-varying forward premia.
Number of Pages in PDF File: 41
Keywords: Electricity market, Forwards and futures, Factor models, Affine processes
JEL Classification: G12, C50, Q40working papers series
Date posted: July 14, 2011 ; Last revised: May 14, 2012
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