Option Formulas for Mean-Reverting Power Prices with Spikes

32 Pages Posted: 15 Dec 2002

See all articles by Cyriel de Jong

Cyriel de Jong

Erasmus University Rotterdam (EUR) - Department of Financial Management; Erasmus Research Institute of Management (ERIM)

Ronald Huisman

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Date Written: October 2002

Abstract

Electricity prices are known to be very volatile and subject to frequent jumps due to system breakdown, demand shocks, and inelastic supply. Appropriate pricing, portfolio, and risk management models should incorporate these spikes. We develop a framework to value European-style options that are consistent with the possibility of market spikes. The valuation framework is based on a regime jump model that disentangles mean-reversion from the spikes. In the model the spikes are truly time-specific events and therefore independent from the mean-reverting price process. This closely resembles the true characteristics of electricity prices, as we show with Dutch APX spot price data in the period January 2001 till June 2002. Thanks to the independence of the two price processes in the model, we break derivative prices down in a mean-reverting value and a spike value. We use this result to show how the model can be made consistent with forward prices in the market and present closed-form formulas for European-style options.

Keywords: power prices, option pricing, regime switches, formulas

JEL Classification: G13

Suggested Citation

De Jong, Cyriel and Huisman, Ronald, Option Formulas for Mean-Reverting Power Prices with Spikes (October 2002). Energy Global Research Paper; and ERIM Report Series Reference No. ERS-2002-96-F&A. Available at SSRN: https://ssrn.com/abstract=324520 or http://dx.doi.org/10.2139/ssrn.324520

Cyriel De Jong (Contact Author)

Erasmus University Rotterdam (EUR) - Department of Financial Management ( email )

P.O. Box 1738
Room T09-53
3000 DR Rotterdam
Netherlands
+31 10 408 2300 (Phone)
+31 10 408 9017 (Fax)

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Ronald Huisman

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

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