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Publication year: 2003

In this paper we develop a general framework for valuation and hedging electricity derivatives. We propose a multi-factor forward curve model consistent with market prices. The electricity forward price is modelled as arithmetic Brownian motion. The main advantage of our model compared to the geometric Brownian forward curve models suggested previously in the literature is that closed form solution to average based derivatives can be easily computed. This is important in the electricity industry, since most contingent claims in this market are derived from (arithmetic) price averages. The dynamic properties of two different average based forward contracts are investigated. Furthermore, closed form solutions to both European and Asian options and corresponding hedge ratios are calculated. Finally we implement the model and provide some numerical examples using data from the Nordic electricity market.

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Publication year: 2001


In this paper we present the first comprehensive analysis of the volatility structure in an electricity market. 6 years of price data on futures and forward contracts traded in the Nordic electricity market is analysed. For the forward price function of electricity, we specify two different multifactor term structuremodels in a Heath-Jarrow-Morton framework. Principal component analysis is applied to reveal the volatility structure in the market. The two most important factors resembles those found in other markets, however, we also find that electricity differs from most other commodities and financial markets in several respects. As much as 10 factors are needed to explain 95% of the variation in the price data. Furthermore, correlation between short and long term structure movements is lower than in other markets. We argue that these special properties occur since electricity cannot be stored.