Pricing Electricity Forwards Under Stochastic Volatility

Abstract

Based on the peculiarities of electricity as underlying commodity of forward contracts we develop a time-continuous pricing model for short-term electricity forwards. The suggested stochastic volatility model utilizes the non-tradeable spot price of electricity and its variance rate as state variables. This enables us to capture the non-linearities, and the high and time varying volatility seen in electricity prices. Using maximum likelihood estimation based on Kalman filtering we report empirical results on electricity data from the Californian market.

Keywords: Electricity forwards, stochastic volatility, time-continuous model, equilibrium pricing, Kalman filtering.

JEL Classification: G13