This issue of The Journal of Energy Markets consists of four papers, all of which build on the use of advanced time series techniques for modeling price risk in electricity and gas markets. These analyses provide insights into the fundamental drivers of risk, and also extend into option pricing and hedging processes. In our first paper, "Exchange rates, oil prices and electricity spot prices: empirical insights from European Union markets", Giorgio Castagneto-Gissey and Richard Green investigate the relationship between the returns for daily electricity spot price, crude oil spot price returns and the exchange rates in six European countries before and after the contagion of the subprime crisis. In many cases, the levels of returns in either the oil price or the exchange rate had little impact on the level of electricity price returns, but the volatility of these prices affected the volatility of electricity prices in most of the European countries examined. Even more significantly, in the later time period (2008-11), the volatility of electricity prices in all of the studied countries was substantially and asymmetrically affected by both exchange rate and oil price returns. This factor risk may have wide implications, not least for the way in which low-carbon generators should be supported.
The implications of volatility for the classic option price model are explored in the issue's second paper: "Pricing and hedging options in energy markets using Black-76" by Fred Espen Benth and Maren Diane Schmeck. The authors give conditions that are necessary for the prices of options on forwards in commodity markets to converge to the Black-76 formula. The conditions in question are that the short-term variations of spot prices must be stationary and the long-term drift must be a random walk. Furthermore, the convergence depends on the speed of the mean-reversion element and the time to delivery. This can be applied to electricity and gas, if spikes are appropriately taken into account, and the practical implications for hedging are illustrated.
In the third paper in the issue, "Pricing and hedging multiasset spread options using a three-dimensional Fourier cosine series expansion method" by Tommaso Pellegrino and Piergiacomo Sabino, a more elaborate pricing and hedging formulation is developed. The authors demonstrate the benefit of applying a Fourier-based model to price and hedge multiasset spread options. Their model is shown to perform well against a full Monte Carlo simulation benchmark, and their approach therefore presents substantial analytical attractions.
In our fourth and final paper, "Evaluating the effects of changing market parameters and policy implications in the German electricity market" by Christian Hendricks and Matthias Ehrhardt, a joint model for German electricity and emission markets is developed using a forward-backward stochastic differential equation. The model uses demand, capacity and fuel prices as its fundamental factors, and extensive empirical analysis in support of the approach is provided. The benefit of a mathematically more advanced approach is again demonstrated. Together, these four papers reveal the benefits that research into the application of advanced analytical methods can provide for energy price risk management, and they help to keep The Journal of Energy Markets at the cutting edge in this field.
Derek W. Bunn
London Business School
This paper proves that the prices of options on forwards in commodity markets converge to the Black-76 formula when the short-term variations of the logarithmic spot price are a stationary Ornstein-Uhlenbeck process and the long-term variations are following...
Evaluating the effects of changing market parameters and policy implications in the German electricity market
In this paper the authors introduce a joint model for the electricity spot and the emission market in Germany. The model is used to simulate the effects of changing market parameters and policy implications.
Exchange rates, oil prices and electricity spot prices: empirical insights from European Union markets
This study investigates the relationship between daily electricity spot price returns and both the crude oil spot price return (in US dollars) and the exchange rate return in six European countries (France, Germany, Italy, the Netherlands, Spain and the...
Pricing and hedging multiasset spread options using a three-dimensional Fourier cosine series expansion method
The aim of this paper is to show the benefit of applying a three-dimensional Fourier cosine series expansion method in order to price and hedge multiasset spread options.