Risk and Reward at the Speed of Light: A New Electricity Price Model
7 Pages Posted: 30 Jan 2003
Date Written: September 2002
In this paper, we argue that, in a deregulated world, the most important challenge facing firms is to understand and appropriately model the price dynamics they face. Models of the price-dynamics process are the basis for computing the value of contracts, investments, or assets under uncertainty and for optimizing operating decisions. Recent research suggests that an excellent way to value assets and contracts in deregulated electricity markets is to view them as a series of real options (Deng, Johnson, Sogomonian, 1998; Hsu, 1998; Pilipovic, 1998). For example, a power plant represents the right, but not the obligation, to turn fuel into electricity every hour - a real option. Another example would be a transmission line, which can be viewed as a call option on the basis spread in electricity prices. All valuation exercises rely on understanding the dynamics of prices, which is the focus of this paper.
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