Pricing electricity derivatives within a Markov regime-switching model

TL;DR

This paper develops analytical formulas for pricing electricity derivatives using a 3-regime Markov model with spikes and drops, incorporating risk premiums due to non-storability, and applies it to EEX market data.

Contribution

It introduces a novel 3-regime Markov switching model for electricity prices and derives analytical pricing formulas for derivatives considering risk premiums.

Findings

Model accurately fits EEX spot prices

Derived explicit formulas for European options and forward prices

Validated pricing approach with market data

Abstract

In this paper analytic formulas for electricity derivatives are calculated. To this end, we assume that electricity spot prices follow a 3-regime Markov regime-switching model with independent spikes and drops and periodic transition matrix. Since the classical derivatives pricing methodology cannot be used in case of non-storable commodities, we employ the concept of the risk premium. The obtained theoretical results are then used for the European Energy Exchange (EEX) market data. The 3-regime model is calibrated to the spot electricity prices. Next, the risk premium is derived and used to calculate prices of European options written on spot, as well as, forward prices.