A structural risk-neutral model for pricing and hedging power derivatives (Q2847237)

This paper studies the pricing and hedging of electricity derivatives by introducing a structural model for spot electricity prices which takes into account factors like the demand, capacity and fuel prices. In particular, the impact of the production capacity scarcity on the spot electricity prices is described. To explain large price spikes, a multiplying factor which allows the deviation of the electricity spot price from the marginal fuel price when the demand is approaching the limit of the capacity is introduced. The demand for the electricity and the production capacities of different fuels are modelled as diffusion processes. Whereas, the prices of the fuels are described by independent geometric Brownian motions. With the presence of the factors like electricity demand and production capacities, the market is incomplete. Using forward contracts on fuels and electricity as hedging instruments, the paper explores the application of the local risk minimization approach to value and hedge electricity derivatives. (Semi)-analytical pricing formulae for the European electricity derivatives such as electricity spread options and options on electricity forwards are derived. The impacts of the electricity demand and production capacity on the risk premium of the electricity price are studied. Numerical results based on independent Ornstein-Uhlenbeck processes for the demand and capacity are provided.