Pricing Forward Contracts in Power Markets By the Certainty Equivalence Principle: Explaining the Sign of the Market Risk Premium

Journal of Banking and Finance 32, Issue 10, (2008), pp. 2006-2021

29 Pages Posted: 1 Nov 2006 Last revised: 11 Mar 2013

See all articles by Fred Espen Benth

Fred Espen Benth

University of Oslo

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Ruediger Kiesel

University of Duisburg-Essen - Faculty of Economic Science

Date Written: December 14, 2007

Abstract

In this paper we provide a framework that explains how the market risk premium, defined as the difference between forward prices and spot forecasts, depends on the risk preferences of market players and the interaction between buyers and sellers. In commodities markets this remium is an important indicator of the behavior of buyers and sellers and their views on the market spanning between short-term and long-term horizons. We show that under certain assumptions it is possible to derive explicit solutions that link levels of risk aversion and market power with market prices of risk and the market risk premium. We apply our model to the German electricity market and show that the market risk premium exhibits a term structure which can be explained by the combination of two factors. Firstly, the levels of risk aversion of buyers and sellers, and secondly, how the market power of producers, relative to that of buyers, affects forward prices with different delivery periods.

Keywords: Contango, backwardation, market price of risk, electricity forwards, market risk premium, forward risk premium, forward bias

JEL Classification: G12, G13

Suggested Citation

Benth, Fred Espen and Cartea, Álvaro and Kiesel, Ruediger, Pricing Forward Contracts in Power Markets By the Certainty Equivalence Principle: Explaining the Sign of the Market Risk Premium (December 14, 2007). Journal of Banking and Finance 32, Issue 10, (2008), pp. 2006-2021. Available at SSRN: https://ssrn.com/abstract=941117 or http://dx.doi.org/10.2139/ssrn.941117

Fred Espen Benth

University of Oslo ( email )

Center of Mathematics for Applications
Oslo, N-0317
Norway

Álvaro Cartea (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

Ruediger Kiesel

University of Duisburg-Essen - Faculty of Economic Science ( email )

Essen, 45117
Germany

HOME PAGE: http://www.lef.wiwi.uni-due.de/

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