Empirical Performance of Reduced-Form Models for Emission Permit Prices

38 Pages Posted: 23 Jul 2013 Last revised: 29 Sep 2016

Steffen Hitzemann

Ohio State University (OSU) - Department of Finance

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Date Written: June 2, 2016

Abstract

The design of environmental trading systems induces specific features of the emission permit price dynamics. In this paper, we evaluate the performance of reduced-form models for emission markets that capture these features in a simplified way and are still feasible for calibration to permit spot, futures, and option prices. Using market data from the European Union Emissions Trading System as the world's largest environmental market, we show that appropriately specified reduced-form models outperform standard approaches with respect to both the historical fit to futures prices and the option pricing performance. Moreover, the performance of reduced-form models critically depends on their consistency with the design of the emission trading system.

Keywords: emission permits, price dynamics, option pricing, environmental finance, carbon derivatives

JEL Classification: G13, Q56, C65, C02

Suggested Citation

Hitzemann, Steffen and Uhrig-Homburg, Marliese, Empirical Performance of Reduced-Form Models for Emission Permit Prices (June 2, 2016). Available at SSRN: https://ssrn.com/abstract=2297121 or http://dx.doi.org/10.2139/ssrn.2297121

Steffen Hitzemann (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

P.O. Box 6980
D-76049 Karlsruhe, DE
Germany
+49 721 6084 8183 (Phone)
+49 721 6084 8190 (Fax)

HOME PAGE: http://derivate.fbv.kit.edu/english/index.php

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