The Valuation of Power Options in a Pirrong-Jermakyan Model

Abstract

This article uses a Pirrong-Jermakyan framework to value options on electricity, including daily strike, monthly strike, and spark spread options. This framework posits that power prices depend on two state variables - load and fuel prices. Although variations in load explain a large fraction of variations in power spot prices, power options do not vary strongly with load except very close to the expiry of daily strike and spark spread options due to the strong mean reversion in load. Load mean reversion also affects time decay, and the evolution of implied volatilities over time. I also discuss how to modify the model to take into account the impact of factors other than load and fuel prices (e.g., outages) that affect power prices; I show that a relatively simple modification can capture the effect of these factors on value if they are not very persistent and not priced in equilibrium.

Keywords: electricity, options, derivatives, power

JEL Classification: G13