Determinants of the Premium in Forward Contracts

29 Pages Posted: 21 Mar 2011

See all articles by Christian Redl

Christian Redl

Vienna University of Technology

Derek W. Bunn

London Business School

Date Written: March 21, 2011

Abstract

Whilst the benefits of forward contracting for goods and services have been extensively researched in terms of mitigating market power effects in spot markets, we analyse how the risk in spot price formation induces a counteracting premium in the contract prices. We consider and test a wide-ranging set of propositions, involving fundamental, behavioural, dynamic, market conduct and shock components, on a long data set from the most liquid of European electricity forward markets, the EEX. We show that much of what is conventionally regarded as the market price of risk in electricity is actually that of its underlying fuel commodity, gas; that market power has a double effect on prices, insofar as it increases spot prices and induces a forward premium; that oil price sentiment spills over and that the premium reacts to scarcity and the higher moments of spot price uncertainty. We observe that considerations of the scale and determinants of the forward premium are at least as important as the market power effects in spot market price formation when evaluating the efficiency of wholesale power trading.

Keywords: Electricity, prices, risk, forward contracting, market power, spillover

JEL Classification: Q40, C10, G13

Suggested Citation

Redl, Christian and Bunn, Derek W., Determinants of the Premium in Forward Contracts (March 21, 2011). Available at SSRN: https://ssrn.com/abstract=1791677 or http://dx.doi.org/10.2139/ssrn.1791677

Christian Redl (Contact Author)

Vienna University of Technology ( email )

Karlsplatz 13
Vienna
Austria

Derek W. Bunn

London Business School ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
0207 000 8000 (Phone)

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