At the flick of a switch

Jesper Andreasen and Martin Dahlgren present a regime-switching model for electricity derivatives that incorporates spiky spot-price dynamics and allows for closed-form pricing of forwards, options and swaptions

Electricity is a commodity that is extremely difficult to store. This means that even small temporary shocks in demand or supply can result in very abrupt short-term changes in prices, the so-called spikes. It is well-known, andwell-documented, that upward price spikes occur in electricity prices, but in some markets downward spikes can actually also occur. As an example of this, consider Figure 1, which shows a time series of the logarithm of the daily spot electricity price, for 2004, on the