Pricing Forward Contracts in Power Markets By the Certainty Equivalence Principle: Explaining the Sign of the Market Risk Premium

Abstract:     
In this paper we provide a framework that explains how the market risk premium, defined as the difference between forward prices and spot forecasts, depends on the risk preferences of market players and the interaction between buyers and sellers. In commodities markets this remium is an important indicator of the behavior of buyers and sellers and their views on the market spanning between short-term and long-term horizons. We show that under certain assumptions it is possible to derive explicit solutions that link levels of risk aversion and market power with market prices of risk and the market risk premium. We apply our model to the German electricity market and show that the market risk premium exhibits a term structure which can be explained by the combination of two factors. Firstly, the levels of risk aversion of buyers and sellers, and secondly, how the market power of producers, relative to that of buyers, affects forward prices with different delivery periods.

Keywords: Contango, backwardation, market price of risk, electricity forwards, market risk premium, forward risk premium, forward bias

JEL Classifications: G12, G13

Working Paper Series