Capturing the power options smile by an additive two-factor model for overlapping futures prices

TL;DR

This paper introduces an additive two-factor model for electricity futures prices using NIG Lévy processes, ensuring no-overlap arbitrage, and effectively fits European power option prices to reproduce implied volatility profiles.

Contribution

The paper presents a novel additive two-factor model with no-overlap arbitrage constraints for electricity futures, calibrated to power options and capable of capturing diverse implied volatility shapes.

Findings

Model accurately reproduces implied volatility profiles.

Calibration procedure respects no-arbitrage conditions.

Effective fit to European Energy Exchange power options.

Abstract

In this paper we introduce an additive two-factor model for electricity futures prices based on Normal Inverse Gaussian L\'evy processes, that fulfills a no-overlapping-arbitrage (NOA) condition. We compute European option prices by Fourier transform methods, introduce a specific calibration procedure that takes into account no-arbitrage constraints and fit the model to power option settlement prices of the European Energy Exchange (EEX). We show that our model is able to reproduce the different levels and shapes of the implied volatility (IV) profiles displayed by options with a variety of delivery periods.